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Financing; Home equity vs 401k vs other
3

Financing; Home equity vs 401k vs other

Financing; Home equity vs 401k vs other

(OP)
For the 1st year startup expenses, I am thinking that tapping into my home equity would be the best way to finance a startup, rather than pull out my 401k with my current employer and take the penalty and taxes hit.

Feedback or suggestions?

RE: Financing; Home equity vs 401k vs other

What happens if business fails?  You can get another job and build up 401 again, but it's hard to do if you default on your mortgage and have to live in your car.

RE: Financing; Home equity vs 401k vs other

(OP)
If It fails, the backup plan is to get a regular job before going totally broke.   The 401K would still be there as the last resort.

RE: Financing; Home equity vs 401k vs other

Get your home equity loan limit increased BEFORE you quit your day job.

I would do the home equity in preference to the 401k loan.  Your house will appreciate with or without your loan.  Money taken out of your 401k will not appreciate.

I personally would save cash until I had the startup costs covered and use the HELOC/401k to cover the unforseen (ie not being able to find a regular job after the startup fails).  That said, only you know your financial situation and risk tolerance.

-b

RE: Financing; Home equity vs 401k vs other

I think retirement money should be a last resort, always.  Once it is gone, you can't put it back.

Check with a financial planner about what happens to your 401K when you leave your employer.  If you take the money and use it you pay taxes and a penalty.  Sometimes you can leave your money in the employer's plan, other times you have to roll it over into an IRA.  Ask about rolling it over, then converting to a Roth IRA as well.  You'll pay tax on the conversion, but there is a benefit.  Contributions to a Roth can be withdrawn tax and penalty free, but proceeds can not.  Find out if your rollover amount would be considered a contribution.

That said, it is simpler to get a loan on your home than it is to play with your retirement money.  Also, the value of your home should mostly cover the loan, and you can sell if things go that badly.  Once your retirement money is gone, you can't get that back.

RE: Financing; Home equity vs 401k vs other

What kind of business?  Solo, or with employees?  Spare bedroom, or leased office suite?  Brainpower-experience-knowledge consulting, or producing a product that requires shop facilities?  All the "essential" gadgets like Blackberry, etc., or just piggyback on your house phone?

The financial needs are a lot different for those different choices.  The financial sources are likewise a lot different.

If you're going solo, then bootstrap it.  Make a family budget, then reduce it drastically and cut it to the bone.  Live under that budget (it'll be good practice) and save the difference until you have some cash to burn.  Then start your business.  If you don't USE a lot of money, then you don't NEED a lot of money.  it worked for me.

After you have some regular clients and cash flow, then the banks will be beating down your door to give you loans.  After that you can live large.

TygerDawg

RE: Financing; Home equity vs 401k vs other

I did both.

I cashed out... 401K and home equity....every cent... every bit of it. I even borrowed money from the family.

Faith, confidence and guts, either you got it or you work for someone else.

Life is good, make the most of it.

Charlie
www.facsco.com

RE: Financing; Home equity vs 401k vs other

If you borrow against your home and things don't work out, you can always cash in the 401-K to cover payments. Besides, even if things don't work out, you don't have to repay the enire loan, just keep up the payments. Hopefully you can get a job again if things do not work out. If you have Whole life, you can generally borrow against the cash value at a very reasonable rate. Going into business is great, getting yourself overextended is not. Don't go crazy.

RE: Financing; Home equity vs 401k vs other

Quote (bvanhiel):

Get your home equity loan limit increased BEFORE you quit your day job.

This could be a half truth, depending on how much you already owe, how much you plan to spend, and how much you are willing to gamble before you fold.

There are different facets to this equation.

1) having a big ceiling may embolden you to spend more. (it's a very common problem)
2) having it raised now may embolden you to gamble longer, when you should be pursuing other options
3) a bank would rather raise your limit WHEN you need it, as long as you are still paying. (rather than have the expense of foreclosure - especially in such a sluggish RE market)

You have a lot of leverage with home equity, but I wouldn't get too excited to shoot for the moon.  I had a relatively small home equity line, and it was doubled for me at bank suggestion when I began to approach the limit.

-----------------------------------------------------------
Catia Design|Catia Design News|Catia V5 blog

RE: Financing; Home equity vs 401k vs other

Solid7,

Points 1 & 2 I agree require caution, but if they're really a problem then maybe self employment's not for you.  It's on point 3 that I think your getting way off track.  Getting your line of credit bumped up a few grand is one thing, getting it bumped up 100k is another.  The process for getting a big equity line extension can be as involved as getting the mortgage in the first place.  They look at income, debt ratios, and a new appraisal if necessary.

It's generally pretty difficult (read: impossible) to get a loan if you don't have any income.  Most banks won't consider self employment income until you've been in business for 2 years.  BTDT

You NEVER want to go to the bank to borrow when you NEED money.  That makes you a bad risk in their eyes, and most banks won't take it.

-b

RE: Financing; Home equity vs 401k vs other

I have to disagree with you for the most part.  It seems you have "old school" thinking. (no offense intended - let me explain)

First off, I did not mean to sound irresponsible.  I urge anyone to be cautious with credit.  It's like a drug for the working class, and it's very easy to come by.  Banks will fall all over themselves to give you a loan these days - to the point that prudence is YOURS to exercise, not theirs.  Additionally, it is NOT hard to get an equity extension.  It's much harder to get the line, in the first place.  Extensions are almost "dive-thru" processes, these days.

Case in point - after having been in business for less than 10 months, and with no income, my bank took it upon themselves to raise my home equity.  They asked me to come in and sign the papers.  I did, and was grateful, because we had a $25K limit, and they raised it to $50K.  Normally, I would say be careful.  But it worked out good for me, because it helped to fund a venture that started making money right away. (and I'm doing well)

So, where I accused you of being "old school", is on this point:

Quote (bvanhiel):

You NEVER want to go to the bank to borrow when you NEED money.  That makes you a bad risk in their eyes, and most banks won't take it.

If you haven't had a need to go to the bank in awhile, I applaud you for it.  However, on this point, you may be the one out of touch.  I doubt that my experiences are regional.  But it may have to do with other things.

Right now, I have considerable leverage on my home, because I bought it at $100K, and less than a year later, it went to $200K.  This happened recently all over the country.  When you figure that into the equation, and look at the boom in the rental market right now, it's not hard to see why a bank may compete for your debt, and not think twice about raising home equity - especially if you bought before the "boom".

On points 1 and 2, you are right - one must ponder these carefully before taking the plunge.

-----------------------------------------------------------
Catia Design|Catia Design News|Catia V5 blog

RE: Financing; Home equity vs 401k vs other

Solid7,

A bank does not prefer to raise the equity limit of someone with no income to someone with a job.  If you get the loan, you will be paying a higher rate.

Your experience went well because you didn't need to prove your income.  

The reason you didn't need to prove income because you were only borrowing a small percentage of your homes equity.  25k is not a big increase (my credit card company will give me that based on nothing at all) and therefore does not require the same level of paperwork.

My experience (which is less than 2 years old) involved getting my limit pushed to within 90% of my homes equity.

I'll stand by that quote:

Quote (bvanhiel):

You NEVER want to go to the bank to borrow when you NEED money.  That makes you a bad risk in their eyes, and most banks won't take it.

-b

RE: Financing; Home equity vs 401k vs other

Quote (bvanhiel):

A bank does not prefer to raise the equity limit of someone with no income to someone with a job.  If you get the loan, you will be paying a higher rate.

Many banks these days don't care whether you have a job or not, as long as you have payment history.  I've seen banks raise equity limits for people who were paying their mortgage OUT OF THE HOME EQUITY. (some irresponsible friends of ours, in fact) surprise  pipe

I didn't have a job, at the time.  In fact, self-employed people have a harder time, quite often, getting loans, because it's not considered a "job", per se.  Every time that I have to apply for new credit, I usually end up having to open up my books.

Higher rates?  I don't think so.  Not me, anyway.


Quote (bvanhiel):

Your experience went well because you didn't need to prove your income.

At the time, I didn't have any to prove.  And to raise a limit, most people probably won't have to, either, so long as their payments are in good standing.

Keep in mind, I'm not suggesting this is true for the initial application.

-----------------------------------------------------------
Catia Design|Catia Design News|Catia V5 blog

RE: Financing; Home equity vs 401k vs other

I started my business with a loan against my 401K and I would recommend this to anyone.  I looked at it as a rock-solid avenue to invest my 401K money at a 6% return.  This is the very definition of a win-win.  I just wish the ceiling on the loan amount were higher so I could invest more of my future in my current success.  

It seems that everyone above is looking at mitigating risk in a failure.  I'm looking at maximizing my return in a success.  The failure scenario also supports the 401K loan direction since if you find yourself in a position where you can't meet the 401K payments you can always let the loan collapse and pay the early-withdrawal penalty.  The bank isn't that forgiving.

The excellent points that TygerDawg raises above need to be considered carefully.  A $50k loan against your 401K may be plenty for a brains-for-bucks operation out of your garage (it was for me), but there is no way that it will cover start-up costs for a manufacturing operation.

Whatever your source of start-up capital, make sure that you have enough to keep you swimming strongly for at least 6 months.  The time it takes to be established in a large company's vendor list, plus the typical delay in paying can put your first check well into 4-6 months from when you start.  I did a budget for both the business and the family, deducted capital requirements (mostly computers and printers) and made sure that I started with at least enought to cover 6 months.  It turned out that I got a big retainer in 3 months and haven't had to hit the reserves, but having them available (and growing at 8% in very liquid mutual funds) is a really good feeling.

David

RE: Financing; Home equity vs 401k vs other

I'm a very young man with no 401K option.  It's great if you have it, but I never got enough built in to use it like you have described.

-----------------------------------------------------------
Catia Design|Catia Design News|Catia V5 blog

RE: Financing; Home equity vs 401k vs other

Solid7,

The difference in the loan your describing and the one I'm describing is the amount.  Raising a limit a few thou (or 25) doesn't require any real paperwork on the bankers part.  They can use the stuff that's already on record, and do a paper appraisal.  That's why you and your friend could get an equity line increase with no hassles.  It's when you're borrowing a significant amount of your homes equity that the banker needs to redo the paperwork to submit to the underwriter.

If you're trying to be ready to borrow all the equity you can, then you'll need to submit paystubs and credit information.  Essentially you submit all the same stuff as when you got the original mortgage.  

A broker can do a "no documentation" loan, but you can bet that the terms arn't that great.  That usually only happens when there's plenty of equity so that the bank can recover the loan amount if they foreclose.

When I did my loan my weekly poker game was with a group of mortgage brokers.  One of the guys was even a loan officer at a branch of my bank.  I know if there was an easier way they would have found it.

The reason I'm so adamant in presenting my case is that you are the exception that proves the rule.  You happen to have a great deal of equity and are only borrowing a small percentage of it.  Most people are not in the same position, and if your starting a business you'll want access to ALL of your equity if you need it.  You won't be able to get that access once you don't have an income.

-b

RE: Financing; Home equity vs 401k vs other

(OP)
I've decided to go with the equity loan.  I also ran it by a conselor at SCORE and he thought it was a good way to go too, and that many people start up that way.  

I also like the fact that the 401k is untouched and continues growing, as one of you mentioned.  

The mortgage company did ask for my most recent pay stub and tax assesment, and ran some sort of online estimate.

RE: Financing; Home equity vs 401k vs other

Good choice, rlee.  I'm sure you will be able to keep track of your cashflow and balance sheet.  Good luck to you!


Someone mentioned that he was investing his 401k money at 6% because he took out a loan againt it...

I can't speak for that particular 401k - it may be a "funny" one that has its own rules, but typically, a loan against a 401k screws you two ways.  1)You have to pay interest, in this case 6%, on the money that you have in it.  This interest is not tax deductable, and by the way, the money in the 401k account is *YOUR* money.  You earned it, you put it there, now you are paying to borrow your own money.  2) The portion of the 401k that you borrow reduces the investment balance of your account by at least that amount.  i.e., the money you borrow stops earning interest or performing as an investment.

#1 plus #2 can add up to big numbers.  For example, if your 401k has been earning 6%, then you are out the 6% you are paying on the interest on the loan and the 6% you would have been gaining in investment income, for a total of 12%.  If it was earning 10%, you are out 16%. Ouch.

There was also a misstament about leverage.  In the banking world, leverage is the ratio of debt to equity, and the bigger the number the more the leverage.  So, the more money you borrow against the value of your home, the greater your leverage.

RE: Financing; Home equity vs 401k vs other

The way I understand 401K loans, the interest you pay goes into your 401K so you are not losing anything.  If you borrow at 6%, you pay someone the 6%.  If you borrow from the 401K, you lose the 6% but get it back for a wash.

Don Phillips
http://worthingtonengineering.com

RE: Financing; Home equity vs 401k vs other

Don, you're right.  My mistake; I should have been talking about the difference between the rate you are earning and the rate you are paying, i.e., 10-6 equals 4% lost.  The problem with this is investment gains are talked about as though they happen gradually, but in reality, they happen in spurts that are relatively short.  Interest payments are a constant percentage over time.  That gets into investment guidance though, outside our scope.

RE: Financing; Home equity vs 401k vs other

If you convert your 401(k) to a "single k" under your own business, then you can get a loan against up to 50% of the value.

While this takes the money out of the market, as you pay the loan back, the interest goes to the company, which in this case would be you.

It's kind of nice to get a loan and then pay yourself interest.

RE: Financing; Home equity vs 401k vs other

In my opinion borrowing from your 401K should be the second last thing you do with your $401k.  The last thing would be taking a hardship withdrawal.  

As Kbro stated, the money you borrow from "yourself" is no longer earning and this can cost tens of thousands in the long term.  Also, and I think this is the real kicker,  when you pay it back you pay it back from after-tax dollars and then when you withraw it at retirement you pay taxes AGAIN.

So $100 borrowed means you have to earn $120 to pay it back more or less.

Also, as far as I know, as soon as you quit your current job, your 401K loan becomes "due"

RE: Financing; Home equity vs 401k vs other

(OP)
As I mentioned in a previous post, I went with the home equity loan and so far feel that it was the right thing to do.  

Also of note, after I started the business and set up a bank account, the bank was surprisingly helpful and I was able to get a small line of credit in the corporations name, $15K, from the bank.  It's not a lot, but it's a beginning toward building credit in the company's name and I'm grateful for it.

Richard Lee
www.led-inc.com

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