Dropping home values crunch credit lines
As home values fall, home equity credit lines -- a favorite cash source for entrepreneurs -- are vanishing.
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| Marcia and Tom Blackwell scaled back their business operations when the bank froze their home-equity line. |
SAN DIEGO (CNNMoney.com) -- When Marcia Blackwell and her husband Tom founded Blackwell's Organic Gelato in 2005, they did what many small business owners do: They funded their efforts with a home equity line of credit. The interest rate was then about half that of a traditional business loan, even one backed by the Small Business Administration, and the money was available fast.
"It seemed like a smart business decision. I could get a line of credit and I didn't have to deal with the SBA scrutinizing me," says CEO Marcia Blackwell. She used the home equity line of credit, or HELOC, for just about everything for her Long Branch, N.J. business, from gelato ingredients and packing materials to the rent on space in a commercial kitchen.
Last October the company was doing well and seemed about six months away from becoming profitable, says Blackwell. That's when her bank called to say it was freezing the HELOC at $190,000 and would not allow her to use it any longer. She hadn't missed any payments, but that didn't matter. The bank's concern was that Blackwell's house had lost 30% of its value.
It was a financial wake-up call. Frugal to begin with, Blackwell cut costs even further and now keeps very little inventory on hand. Unable to stock up on supplies, she asks distributors to give her advance notice of big orders. "We have stopped all unnecessary spending, we cut out any marketing and advertising and I'm not paying myself," she says.
Blackwell's situation is not unique. Small business owners often use home-equity loans for liquidity, but now banks are freezing those lines of credit -- often without any notice. For businesses already running close to the edge, that can be a death knell.
Vino Pajanor, president of the Housing Opportunities Collaborative, a San Diego nonprofit that runs walk-in clinics and seminars for at-risk homeowners in southern California, estimates that 15% to 20% of those seeking help from the Collaborative are small business owners either in crisis or preparing for one.
"They used a home equity line for daily operation of the business and it's frozen," he says. "If they can't run the business, they can't make money to pay the mortgage, and it becomes a viscous cycle."
A $100,000 home-equity credit line helped the owner of a small auto parts dealership in New Jersey keep inventory stocked. A few months ago, that home equity line was frozen, says the dealer, who asked that his name not be used. "No reason whatsoever. We were making payments. They felt my net worth versus what was owed was too high," he says. "We cut our inventory by 40% and cut the number of trucks on the road in half. Now we are constantly paying more than we should for parts, because we can't buy ahead of time in bulk and get discounts."
As home equity lines vanish, other avenues of small business financing are also running dry. More than 40% of small business owners polled in April by the National Small Business Association said the limits on their credit cards had been cut in the past year, and 63% said their interest rates went up. Bank lending is in freefall. Even with stimulus incentives, the SBA backed 30% fewer bank loans to small businesses last quarter than it did a year earlier. The agency's lending volume has dropped to less than half what it was before the recession set in at the end of 2007.
The allure of home equity loans is their liquidity: Business owners can tap cash without submitting detailed business plans. But easy access can be a double-edged sword.
"Used properly, home equity lines of credit are great and get the job done. But a business that isn't self-sustaining can't pay it back, and that's where the problem lies," says Norm Bour, a debt management strategist and founder of BusinessCashFlowPros.com in Laguna Niguel, Calif.
The scrutiny a loan officer gives to a business plan before signing off on a commercial loan can pay off for entrepreneurs in the long run. "It makes them think: 'If this happens, where will the money come from?' Too many people run their small businesses by the seat of their pants instead," Bour says.
If you run a business and still have a credit line available, drawing it down now might pay off later. A borrower could take the entire amount and put it into a money market account or CD.
"Don't just let that $50,000 sit there, because the bank could easily freeze it. Instead, it becomes insurance that you will have liquidity," says Wes Moss, author of Starting From Scratch and chief investment strategist at Capital Investment Advisors, a fee-only investment advisory firm in Atlanta. "Although it may not seem to make financial sense -- you will be paying a higher interest rate to use the home equity money than you will be earning on it -- it's worth it for the peace of mind."
For those whose credit lines have already been frozen, there's no easy alternative for fast operating cash. Without collateral like a vacation home or valuable business inventory, it's almost impossible to get a bank loan. The best bet may be smaller, local banks or lenders that specialize in your specific industry.
"A community bank may focus more on the personal stuff -- that you've been paying your bills on time -- rather than what needs fixing in your business situation," says George Cloutier, CEO of American Management Services, a turnaround consultancy for small to mid-sized businesses in Orlando, Fla.
Another option is the SBA's America's Recovery Capital (ARC) program, which began in June and offers banks a 100% guarantee on loans to viable small businesses that need help making payments on existing debt. Business owners can borrow up to $35,000, interest-free, to cover their debt payments for six months. But the loans are only available to businesses that have turned a profit in at least one of the last two years -- and even those who qualify say they're having a hard time finding banks willing to make the loans.
If you need to cut your overhead, try talking to your creditors and suppliers. In this economy, it's possible to renegotiate just about everything, from the amount you pay for rent to the credit lines you have from vendors, Cloutier says. Desperate business owners have resorted to raiding their 401(k) plans or other retirement accounts, but attorney Paul T. Gregory, with New York City firm Herrick, Feinstein, advises his business clients against that. "It's never a good idea to tap into your retirement," he says. Not to mention the 10% penalty tax you will pay in addition to income tax.
In the end, you may simply have to decide how long your business can survive, says Cloutier, who has seen many small business owners hang on "well beyond human limits. Many times when someone's goose is cooked twice, they come through it through sheer guts and perseverance," he says. "I see it everyday." 
