Is Using Your Home as Collateral on a Business Loan a Good Idea?

A reader once wrote me an email stating the bank she wants to borrow from wants $50,000 from her personal residence as part of their collateral for the loan. She approached the California bank about loaning her money to buy a piece of equipment. Her business is a start-up that will use this piece of equipment to conduct services for other businesses.

This is a really touchy issue with me. My entire banking career has been in Texas, which is a state that doesn’t allow borrowers to use equity in their home as collateral as a business loan. I think that is a very good law. I have never made a loan and used a personal residence as part of a loan collateral package.

I tried to do some research to determine how many states allow this practice and if there are any states that allow the use of personal residence with specific restrictions that may be important for borrowers to consider. I didn’t find any solid reliable data about this practice nationwide.

Why using your home as collateral is not a good idea

At first, it might seem like the laws in states that do allow use of your primary residence as collateral on business loans offer a good opportunity for the borrower. Many borrowers, especially start-up borrowers, may have most of their net worth tied up in their residences. In the past, I have assisted clients in Washington, Louisiana, Massachusetts, and California who were in trouble with their business loans.

In each of these cases, the businesses I was helping had been strong businesses before the recession. In one case two major natural disasters in three years decimated the community of my client. Sales plummeted and the bank began foreclosing on both the business assets and the personal residence of the borrower. The other two were hurt by the very weak economic conditions in their communities.

I was asked by all three borrowers to negotiate an offer in compromise with each of the banks so the bank doing the foreclosure would leave the personal residence alone and simply take the business assets of the company.

In each of my client’s cases, they didn’t think to try to negotiate out their personal residence from the bank’s collateral at the time the loans were made. Perhaps they didn’t know the issue was negotiable. The truth is that a bank or some types of non-bank lenders will take every single piece of collateral they can to secure their loan, whether it makes sense or not.

What to know about using your house as collateral for a business loan

I would give these pieces of advice to anyone seeking a business loan (especially in states where banks routinely want to take as collateral a personal residence).

1. Before the loan is made, collateral required by the bank is negotiable.

Once the loan is made, it is close to impossible to get a piece of collateral released. In the case of the business that wrote me, it seems fairly unreasonable for a bank to require as collateral the owner’s personal residence for a small $50,000 loan where the equipment being financed is brand new and has a decent orderly liquidation value. There are banks in the market today all over the country that are making $50,000 loans unsecured with simply the personal guarantee of the borrower.

For financing a piece of equipment there are better options than risking your personal residence by giving it up as collateral. Seek a leasing solution. Lessors do secure their lease with collateral, but it is normally limited to the piece of equipment being financed.

2. If you have rental property, raw land, or a vacation home that has equity offer one or more of those properties as collateral rather than your personal residence.

What has happened over the years is that instead of benefiting the borrower by using their personal residence as collateral on a business loan, it has become the defacto standard for banks to require it. This is a poor way for a commercial bank to act. It is important for the bank to have enough collateral to support their loan, but often when they take the “blanket” approach they may have 200% or more value of collateral-to-loan coverage.

3. For a small loan, a credit union that makes business loans might be a more suitable solution than a bank.

Credit unions (because they are member-owned) are much more likely to exclude personal residences from their collateral requirements because they, like me, often feel it is unreasonable to ask for a personal residence as collateral.

Explore other options for collateral

Small business owners risk financial ruin when they begin a business, often undercapitalized. The owner should want to feel secure that even if his business fails, he won’t become homeless.

It is important to have this conversation about collateral fairly early in the process of requesting a loan. Find out if your state is one that allows the use of equity in the owner’s primary residence as collateral. Then ask your banker what their bank’s position is on the topic. Investigate other sources of loans, such as loans from CDFI lenders and leasing companies (if the financed collateral is leasable).

FAQs about using your home as loan collateral

Below we have summarized the most important questions and answers on the subject.