Should you finance your business with a home equity loan?

The small business sector of the US is often called "the backbone of the economy," and the "engine of job creation." Its importance is the reason the Small Business Administration (SBA) backed over 50,000 loans to the tune of nearly $20 billion in 2014. However, the majority of small startups have an extremely difficult time getting financing.

The trouble with business loans

According to the National Federation of Independent Business, the smaller you are, the less likely you are to obtain traditional business financing. Only about 15 percent of sole proprietorships have business loans, according to NFIB researchers.

One of the obstacles to traditional small business financing is the amount of paperwork required. Here is a partial list of documentation required for many business loans: personal background/history, personal financial statements, one-year projection of income and finance for the business, loan application, personal and business federal income tax for previous three years, business lease, business license, and business plan. Small business advisers warn that the process can take months.

Home equity advantages

If you have a great idea and want to get up and running fast, home equity financing is likely your fastest and cheapest alternative. You don't have to explain what makes you qualified to start a business, justify the fabulous-ness of your idea, and come up with a batch of financial projections. Home equity interest rates are also typically much lower than those of business loans. So why doesn't everyone do this? Well…

Home equity trade-offs

There is a downside to this cheap and easy money. By forcing applicants to hop through many hoops, create business plans, and analyze their finances, business lenders produce better-prepared entrepreneurs. This reduces the risk to the lender and increases the chance that the business will succeed. Home equity lenders, however, only concern themselves with your personal resources. If you have the income, equity, and credit rating to repay the loan, you're good to go. The interest rate is lower because the mortgage lender does not shoulder the risk of your business -- you do. If your great idea turns out to be less-than-great, you still have to repay the loan or lose your home. Considering the 90 percent failure rate of small business startups, that's a risk that you should evaluate very carefully.

Mistakes to avoid

Just because you can tap home equity to start your business doesn't mean you should. Entrepreneurship educator Susan Shreter writes that "a common mistake of startup entrepreneurs and first-time business buyers is to estimate the funding requirements to start a business, not succeed in business." If the amount of money needed to start and run your business is significantly greater than your resources, don't bet the house. Shreter says that in that case, "Funding your new business with equity from investors rather than debt may be the smarter, risk-adverse way to go."

Other tips for staying in the black are:

• Don't borrow if the monthly payment is more than you can pay if the business doesn't generate income.
• HELOCs come with variable interest rates, which can make budgeting harder. For stability, choose a home equity loan with a fixed rate and payment.
• HELOCs are less expensive to set up, more flexible, and have lower (introductory) interest rates. They can be great if you're using them as an emergency backstop. However, they can be reduced or shut off by the lender if your home value drops, potentially putting your business at risk.
• Expect the unexpected -- delays, increased costs, etc. Could you survive if your startup costs doubled?
• Don't rely on other investors to repay your home equity loans. Some borrowers use their home equity to finance their business with the idea that they'll get up and running and bring in other investors. If that doesn't happen fast enough, you'd be putting your home in jeopardy.

Home equity is not Monopoly money. It may be the only financial security you have, so treat your big idea like a serious business and be realistic about the risks. As many a battered business owner has learned, if you fail to plan, plan to fail.