When applying for a business loan, it makes sense that you should be able to use your inventory as collateral, but that’s not always the case. In some cases, you’ll need property to get the loan you need.
The U.S. Small Business Administration (SBA) [source: https://www.sba.gov/content/collateral] defines collateral as, “an additional form of security which can be used to assure a lender that you have a second source of loan repayment.” Property is the most common type of business loan collateral. Inventory may be used, but only when the type of loan matches the collateral source. Other collateral sources include equipment and cash savings.
Matching Small Business Loans to Collateral Sources
Lenders want to match long-term loans with long-term collateral, such as a building or piece of equipment. Inventory, because it is considered short-term collateral, is best used on a short-term loan. For instance, you could take out a line of credit to take advantage of a bulk-buying opportunity that can increase your sales margins. The inventory you purchase is the collateral and the extra margins you gain by making the bulk purchase assure the bank you can repay the loan.
Collateral Cuts Risk
Lenders are looking to cut their risk when lending money, which is why they require collateral in the first place. Because inventory is a riskier form of collateral, banks will generally allow you to borrow only 30 to 50 percent against its value. Because of this, it’s important to be realistic about the value of your collateral. It’s not necessarily worth what you paid for it, but what the market will bear.
Know the Value of Your Collateral
Getting an unbiased appraisal is a smart way to approach a lender to be sure both parties have a realistic idea of the collateral value from the start. Remember that regulations generally cover loans over $50,000 using real estate as collateral. When using inventory to secure a loan, few protections exist. Some business owners will use their personal assets as collateral, but consider the risk before you make a move like this. If the business defaults on the loan because of market fluctuations over which you have no control, you could lose the home or car that you used to secure the loan.
Reduce Your Risk by Choosing the Right Collateral
Offering the wrong collateral for a loan can make it more difficult to get a loan or make you more likely to default on the loan you get. Banks will ask for collateral that creates the least amount of risk for the bank. You need to use the collateral that creates the least risk for your business and your family.