business loan
We’ll talk about the latter option—SBA and small business loans—in Chapters 3 and 4. Here we will focus on the first two options.
As mentioned, it is much harder to qualify for mortgages, including home equity loans, than it was prior to the housing downturn. You’ll generally only be able to borrow up to 80% of your home’s appraised value, minus any first mortgage.
Your personal credit score will be a key factor in determining which program you qualify for, and the rate you’ll pay. Make sure you check your credit reports at AnnualCreditReport.com at least six weeks before applying for one of these loans, to give yourself time to fix mistakes. While you’re at it, check your credit score for free at Credit.com to get an understanding of where you stand. Keep in mind, though, that for mortgage applications, lenders use a specific version of the FICO score which they will obtain with your credit reports from each of the three major credit bureaus. The middle of the three scores that are returned will usually be used for qualification purposes. You can learn more about credit scores in the 2012 edition of Garrett Sutton’s The ABC’s Of Getting Out of Debt (We will refer to several of Garrett’s books throughout the text. Of course, not every related topic can be included in just one book. So the idea is to provide you with an easy reference point for more information.)
Don’t quit your day job just yet! If you are still working a full-time job, apply for a home equity loan or line of credit while you can still show steady employment. Lenders want to see two years of documented income, and it’s become more challenging for those who are self-employed to get these loans. Unless your spouse can qualify for the loan on his or her income and credit score alone, it’s best to get a loan nailed down before go out on your own.
Home equity loans or lines of credit, as well as “cash-out refi’s” may be available from your local bank or credit union, a megabank, online lender or mortgage broker. Shop around by contacting several lenders or using an online portal, or by hiring a mortgage broker to shop for you. Just try to limit applications to a two-week period to avoid possible damage to your credit score that can result from multiple inquiries. (Mortgage-related inquiries within a 14 or 45 day stretch will usually be counted as one, depending on which credit scoring model is used.)
What’s the downside of using home equity to start your venture? The loan will be reported on your personal credit reports and can affect your credit scores. If you pay those loans on time, however, it shouldn’t create too much of a problem. But if you fall behind on a payment on any mortgage loan—home equity or otherwise—your credit scores will likely plummet, at least in the short term.
Another consideration to keep in mind is the fact that home equity lines of credit typically offer interest-only payments for an initial period, called the “draw” period, which usually lasts for ten years, though sometimes it is shorter or longer. After that period, the borrower can no longer borrow against the line of credit, and must pay the entire loan back—interest plus principal—over a set period of time, which may be 10, 15 or 25 years, depending on the terms of the loan. During this latter period, the monthly payment will likely be substantially higher than during the draw period. So it is crucial to understand the term of the loan and what kinds of payments will be required during that time or you may find yourself in default, or forced to sell your home to pay back the loan.
If you’re thinking of taking out one of these loans, one of the hardest things to do it so put your optimism aside for a moment. Most entrepreneurs are risk-takers; if they weren’t, they’d never venture out on their own. But you need to think about what will happen if it takes longer to get off the ground than you planned. Will you be able to repay the loan? What happens if you can’t?
How Long Is Your Runway?
Emily Chase Smith is an attorney and coach who works with entrepreneurs. She says: “Every business takes twice as much time and twice as much money as you think it will, and we call that your runway. You want to extend your runway as far as you possibly can. Sometimes as small business owners, we just see the vision so clearly, so we go for the big vision and we don’t have a plan for how we’re going to get there. So we might go out and rent a giant office because that’s our vision. We’re going to have this fantastic law firm or we’re going to have this great retail space, to satisfy our vision as opposed to taking the realistic steps to get there. But then we run out of runway. We run out of money and run out of time. Perhaps (if we took it more slowly) we could have had a fantastic business.”
Reverse Mortgages
If you are 62 years or older and you have equity in your home, you may want to consider a reverse mortgage (officially known as a home equity conversion mortgage) instead of a home equity loan.
A reverse mortgage is a federally-insured mortgage, only available to homeowners 62 years or older. You get the proceeds of the loan in one of three ways; as a lump sum, in monthly installments or as you need it (a line of credit). You don’t make mortgage payments, but you are required to pay your taxes and homeowners insurance. And if you get a reverse mortgage on a property that already has a mortgage, the existing loan will be paid off and a new loan put in place.
When you sell your home, or if you die before then, the reverse mortgage is paid off—including interest and fees that have accrued on the loan—and any equity left in the home goes to your heirs or estate. If your home’s value has dropped, however, and there is not enough equity to pay off the reverse mortgage, then the lender takes the loss regardless of other assets you may leave behind.
The advantage of this type of mortgage for an entrepreneur is clear: If it takes you longer to generate cash flow than expected, you won’t be scrambling to make payments on your mortgage or a home equity loan.
In the past, lenders didn’t even look at borrower’s credit reports, making these loans especially attractive to those with past credit problems. But due to losses by the FHA, a “financial review” that includes a credit check is required as of March 2015. That doesn’t mean you can’t get a reverse mortgage if you have bad credit, but it does mean you may need to provide an explanation for how you plan to use funds to pay back currently delinquent debts. Still, a reverse mortgage isn’t reported on traditional credit reports, so taking one out won’t hurt the business owner’s credit history.
These loans can get expensive, and some older people have been sold loans that weren’t appropriate for them. Of course, there is always the risk of sinking your home equity into a business venture that might fail. You can lose your equity and have nothing to show for it. As a result of past abuses in this industry, you are required to get mandatory counseling from a HUD-approved counselor before you can get one of these loans.
On the other hand, unlike a home equity loan, you won’t be kicked out of your house because you can’t make your loan payments. You must keep up with your property taxes and required assessments such as homeowner association dues, though, or you could lose your home. The lender will also require you to keep a minimum amount of homeowner insurance in force to protect the lender in case of a fire or other catastrophe. You will have to be able to document that you can afford to continue to make your insurance and tax payments in order to get one of these loans.
Personal Bank Loans
In the Inc. 500 survey, 13% of respondents said they used personal bank loans to fund their businesses. That makes sense, as it can be hard to get a business loan for a brand-new venture. However, personal loans also carry a tremendous about of risk.
Getting a personal loan will require a personal credit score strong enough to help you qualify for the loan, and a large and steady enough income to support the payments. If you are considering a personal loan for business financing, ask potential lenders the following questions:
