As a business owner, you may need additional funds to support your operations or expand your business. One option to consider is using your home equity to obtain a line of credit. In this article, we’ll explore the concept of a home equity line of credit (HELOC) and how it can be a valuable financial tool for your business.
What is a home equity line of credit?
A home equity line of credit is a revolving line of credit secured by your home or other real estate. It allows you to tap the equity you’ve built in your home and use it as collateral for a line of credit. Think of it as a large credit card, where you can access funds as needed. Some lenders even offer a plastic credit card for convenient access to your funds, while others allow you to transfer funds online or via checkbook.
HELOC vs cash-out refinancing
When considering using the equity in your home, you may also come across the option of a cash-out refinance. With a Cash Out refinance, you’ll pay off your existing mortgage with a new, larger mortgage. The difference between the new mortgage and your existing mortgage, after deducting closing costs, will be given to you in cash.
While a cash-out refinance may seem like a simple option, a home equity line of credit offers more flexibility. With a HELOC, you can keep your existing mortgage and borrow against the equity separately. This is particularly beneficial if you already have a low interest rate on your current mortgage. By using a HELOC, you can avoid refinancing at potentially higher rates and keep your payments the same.
Calculation of the blended interest rate
When deciding between a HELOC and a Cash Out refinance, it’s essential to consider your blended interest rate. The blended rate is the weighted average of the interest you pay on all dollars borrowed. It takes into account both your existing mortgage and the interest rate on the HELOC or new mortgage.
To illustrate this, let’s say you want to borrow $200,000 for business purposes and you currently have a $500,000 mortgage at a rate of 3.25%. If you could refinance at 6%, but the best rate you can get on a HELOC is 9%, you might think the HELOC is a terrible deal. However, when calculating the blended rate, keeping your rate of 3.25% and borrowing an additional $200,000 at 9% gives a blended rate of around 5%. This is more than 1% better than the refinancing option, making the HELOC a more attractive choice.
Benefits and Considerations of a HELOC for Business Owners
A home equity line of credit can be a beneficial financial tool for business owners. Here are some benefits to consider:
Flexibility: A HELOC provides flexibility in accessing funds, allowing you to use them as needed for business expenses, whether to finance improvements, consolidate debt, pay tuition or even make a major purchase.
Emergency reserve: Many business owners create a HELOC as an emergency reserve. This gives you peace of mind, knowing you have quick access to funds to cover unexpected expenses or cash flow shortfalls.
Lower monthly payments: During the draw period of a HELOC, you typically make interest-only payments. This can ease your business’s cash flow, allowing you to manage your finances more efficiently.
However, there are a few considerations to keep in mind:
Variable Interest Rate: HELOCs typically have a variable interest rate, tied to an index such as the prime rate. As a result, your interest rate and monthly payment may fluctuate over time. It is essential to monitor interest rates and prepare for potential increases.
Repayment Period: Once the draw period ends, you will enter the repayment period, during which you will have to repay the principal and interest. This shift from interest-only to repayment can result in higher monthly payments. It is therefore crucial to plan and budget accordingly.
Risk of Property Depreciation: If the value of your home or property declines, your lender may have the right to close your HELOC or restrict further draws. This is an important consideration if you plan to use the funds for specific improvements or events.
Choosing the Right HELOC for Your Business
When shopping for a home equity line of credit, it’s essential to do your research and compare different options. Here are some questions to ask your lender:
What is the margin on the HELOC?
What are the fees associated with the HELOC, including setup fees, annual fees, and early termination fees?
What is the draw period and how long does it last?
What is the minimum payout during the drawing period?
What is the repayment period and what are the terms?
What is the combined loan-to-value (CLTV) ratio and how does it determine the credit limit?
Can HELOC be converted to a fixed rate and payment option?
By asking these questions and understanding the terms of the HELOC, you can make an informed decision that fits your business needs.
In conclusion, a home equity line of credit can be a valuable financial tool for business owners looking for additional funds. By leveraging your home equity, you can access flexible financing options to support your business operations. However, it is crucial to weigh the benefits and considerations, calculate the overall interest rate, and choose the right HELOC for your business needs.