Home equity loans are loans secured by pulling out available equity from a business owner’s personal residence. In this case, the value of the home is used as collateral. Sometimes referred to as second mortgages, they can be a good source of funding for short-term business financing needs and/or when there is reasonable assurance of repayment within a few months. These types of loans are advisable for short-term funding because with home used as collateral, if the loan goes into default the business owner’s home will be forfeited to the bank.
The major advantage of a home equity loan is the tax-deductible interest payments on the loan. This can mean a significant tax saving. In addition, the interest rate secured on a home equity loan is typically much lower than the interest rate on a credit card or personal loan.
The disadvantage of a home equity loan is that loan is offered as a lump-sum payment, where you are charged interest on the entirety of the loan amount, regardless of whether or not you use it. An alternative to this is to opt for a home equity line of credit (HELOC). The HELOC functions the same as a HEC but allows you to draw money from the total loan amount on an as needed basis, allowing interest to accrue only on the amount of funding actually used.
Home equity loans often require the borrower to have good credit. Lenders will look at the Loan-to-Value Ratio (LTV) to determine the maximum possible amount of the loan as well as an individual’s debt-to-income ratio to assess their ability to repay the loan. LTV ratios reach a maximum of around 85% depending on lender policies and an individual’s credit. This means the total amount of the loan (including the original mortgage amount) cannot exceed 85% of the estimated value of the home. The estimated value is the current market value, which may be higher or lower than the price originally paid for the home. In addition, the debt-to-income ratio typically needs to remain below 40, meaning the total amount of monthly debt payments (e.g. credit cards, mortgage) must be less than 40% of an individual’s usual monthly income. This number includes the estimated payment on the new home equity loan.