The Downside of Encouraging Small Business Owners to Tap Home Equity

home equity for small business

The housing bust has adversely affected small business access to credit.

Declining home values have made it more difficult for small business owners to use the equity in their homes to finance their companies. In response, some small business advocates have proposed making it easier for small business owners to tap home equity as a source of business capital.

But that might not be wise public policy.

Many small business owners prefer home loans to business loans as a way to finance their companies, John Harding of the University of Connecticut and Stuart Rosenthal of Syracuse University explain in a recent study.

Home equity loans, they say, are much easier to obtain than business loans, and have tax advantages.

Tapping home equity is a fairly common way to finance a small business. Approximately one quarter of small business owners borrow against the equity in their home for business purposes, or pledge their homes as collateral on those loans, data from Barlow Research, a Minneapolis-based market research firm, show.

Government policies that facilitate the tapping of home equity to finance small businesses encourage entrepreneurship.

A study by Thais Laerkholm Jensen and Søren Leth-Petersen of the University of Copenhagen, and Ramana Nanda of Harvard Business School, revealed (PDF) that a change in the law to allow mortgage loans to be used for purposes other than financing real estate boosted the number of entrepreneurs in Denmark by 4 percent.

But efforts to liberalize mortgage markets might not be great public policy.

Jensen and his colleagues found that the Danish businesses that benefited from the new mortgage rules were significantly more likely to fail than a control group of businesses.

Moreover, if the businesses that benefited from the regulatory change managed to survive, they tended to have lower sales, profits and employment than the other companies.

Letting business owners use home equity to finance their businesses removes the banks as a constraint on entrepreneurial activity, leading more people pursue their business dreams. But this encouragement of entrepreneurship comes at a cost. The marginal businesses that get started tend not to succeed.

Home Photo via Shutterstock

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.