Using your home as collateral: if you're considering it, be aware of what can happen if the business goes under

Nation's Business, July, 1996 by Janine Latus Musick

If you're considering it, be aware of what can happen if the business goes under.

Most first-time business owners bet not just their time and their income on theft dreams, but their family homes as well.

Bankers estimate that at least 90 percent of first-time business owners use their homes as collateral on small-business loans. This statistic is not so surprising if you consider that a new business often does not have enough assets to serve as collateral for the entire loan. But what happens if the business fails? Generally, both private banks and the U.S. Small Business Administration, which backs billions in loans with repayment guarantees to the banks, try to negotiate payment plans that allow the former business owner to repay the debt gradually, without being thrown out of his home.

"SBA's position as far as personal residences is to try to work with the individual borrower or guarantor as much as possible," says Walter Intlekofer, director of loan servicing at the federal agency. "We look at the home as collateral of last resort. We certainly don't want to retain assets, especially not residential real estate."

If a business gets into trouble, the first response by banks and the SBA is to help the owner devise a way to salvage it.

If the business still fails, however, the bank and the SBA come in and sell off any business assets, including inventory, fixtures, and equipment. But that is rarely enough to pay off the whole debt.

"The value of business assets generally amounts to 10 to 20 cents on the dollar," says David B. Keller, president and CEO of Union Planters Bank of Mid-Missouri. "People used to think you could sell the inventory at cost, and you can't."

After the desks, computers, and copiers have been sold, the bank has to look to the borrower to find a way to settle any remaining debt.

When the SBA or a bank accepts a home as collateral on a business loan, they put a lien on the home for the value of the entire debt, even if the debt is more than the owner's equity.

The thinking is that the equity will increase through continued mortgage payments and appreciation of the home-- during the life of the loan. (Any such lienholder's claim would be secondary to that of a primary mortgage holder.)

If the business fails, however, it does not necessarily mean that the home has to be sold to settle the debt. A homeowner who has enough equity in the property can refinance the mortgage, use the equity to pay off the balance of the business loan, and get the lien removed.

A banker in North Carolina tells of a man who persuaded three of his longtime friends to invest in his dream business. The business went under, and the operator skipped town, leaving the three buddies to clean up the mess. Unfortunately for them, each had put his home up as collateral.

While none of them wound up in bankruptcy, each had to refinance and sacrifice hard-earned equity in their homes to cancel the lien. They applied for and received new mortgages on their homes and used the equity they had accumulated over years of paying off their original mortgages to pay off the business debt.

Some people whose businesses fail have that kind of equity in their however, or they are buried under a lot of other debt, so they opt for bankruptcy. Typically, this lets a work out a repayment plan and avoid losing his home to satisfy creditors.

Keller of Union Planters Bank tells of a retailer who, trying to save the business, borrowed money from family members, ran up personal credit-card debts, and borrowed against virtually every other asset.

"Bankruptcy is actually the most common course of action borrowers take," Keller says. "By the time they default on the SBA loan, they have incurred significant unsecured debt, from vendors, credit cards, and sales tax. It's not just the bank and the SBA to repay, it's a barrage, and that's what appears hopeless to most of them."

The SBA has no statistics on how many business owners who used then' homes as collateral choose bankruptcy, "but it is certainly not infrequent," says the SBA's Intlekofer.

Banks try to help clients avoid bankruptcy, however. "If a borrower chooses bankruptcy, there's little chance the bank will recoup the value of the loan," says John Prescott, vice president for loans at Nape National Bank, in California. "Which is why we try to create a payment plan."

The best way to avoid losing your home is to research your market thoroughly and create an effective business plan before you open for business, says Dick Rosenstiel, senior vice president for small-business lending at Today's Bank, in Rockford, Ill.

"You've got to have a game plan upfront," he says. "It's amazing how accurate you can get with your projections. People who don't go through that step believe they just have to stay in business another six months or a year, but by then they have such a large debt [that] they go into a bankruptcy situation."

Most bankers try to talk regularly with business owners to help them reassess their business plans. "The key is recognizing that the business is in trouble as early as possible," Rosenstiel says. "You really get into trouble when the problem has gone on so long and the hole has gotten so big that there's no way to save it."