Employee Loans: What To Know Before Lending Money

Considerations before lending money to employees

Person talks with a loan officer
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Beyond professional advancement and satisfaction reasons, employees stay committed to workplaces that understand and support their needs, including financial stability.

If an adverse life event wreaks havoc on your employee's finances and their current income barely covers the cost (or not at all), what will they do? Workers often quit and seek higher-paying employment elsewhere or take on additional debt to make up the difference when something like this happens.

There is another option, however—one that helps your company and its people: employee loans. Instead of risking them going back out into the job market to find a higher-paying job, you can offer to loan them the funds they need at a significantly lower interest rate.

When you lend small-dollar loans to employees, you help them grow their wealth and invest in their future. It’s an opportunity to forge a long-term commitment between your employee and your company because you are actively involved in supporting their financial needs.

So what does the process of loaning money to an employee look like? How can you handle all the legal details and ensure timely repayment? This article will help you understand the basics of employee loans, how they work, and what to do to ensure it benefits everyone involved.

Key Takeaways

  • Employee loans are beneficial for companies because it’s an investment in their employees' financial future, thereby improving retention.
  • These loans are typically repaid in installments from an employee's paycheck and include the principal amount plus a low interest rate.
  • This method has significant benefits for employees: no credit barriers, lower APR, no collateral required, and automatic repayment options.

What Is an Employee Loan?

Employee loans are temporary funds given to an employee by their employer that the borrower will repay with interest over time. At first glance, it may seem like lending to employees is a risky idea. However, when done correctly, it can be an effective way to reduce the cost of labor by retaining good employees.

Loans can help them meet their financial needs without taking on any personal debt. Employers can make loan funds available for medical emergencies, tuition payments, housing-funds issues, and many more situations.

Pros and Cons of Lending to Employees

Pros
  • Financial security

  • Employee retention and improved work performance

  • Low-risk, affordable financing option

Cons
  • The employee could default on the loan

  • Risk of inequality or favoritism

  • Can complicate workplace dynamics

Pros Explained

  • Financial security: Consistent employee loan repayments plus additional interest can positively contribute to the cash flow. Employee loans also provide financial security for employees as low-risk funds that can help them weather financial storms.
  • Improved work performance and retention: Employer-given loans can alleviate stress and give employees a sense of financial ownership, which may help them perform better at work. Work satisfaction and lower stress encourage them to stay with the business and not seek employment elsewhere.
  • Low-risk, affordable financing option: Employee loans interest rates are generally lower than those of other forms of financing and don’t require a credit check, making this an affordable and accessible option for workers.

Cons Explained

  • The risk of the employee borrower defaulting: Employees who borrow money from their employer may not be able to repay the loan if they lose their job or experience other financial setbacks. To avoid this, include loan loss provisions and default terms into the agreement.
  • The risk of employee conflict: Employee loans could create a sense of inequity between those who have been given loans and those who have not, leading to conflict among employees. To mitigate this, set up an employee loan program with policies, and be consistent.
  • The risk of workplace politics disruption: Staff may try to use these loans as a method of favoritism, which can lead to conflicts between employees and management. The employer should consider all potential consequences of giving employees the option to take out loans before making any decisions.

How Employee Loans Work

Creating a loan agreement is crucial to avoid tax penalties and ensure repayment. To create an employee loan program, follow these five steps:

  1. After an interview, determine how much money to offer based on the employee’s need and repayment ability (their debt-to-income ratio). Or you can offer a fixed amount to all employees equally.
  2. Consult your accountant and a business lawyer to accurately assess the situation (such as the maximum your company can afford to loan and how often), then draft the appropriate agreement document.
  3. Decide who will be your employee-loan plan administrator to sign the paperwork and monitor payroll deductions.
  4. Create a loan-repayment account for the employee with financial software to set up automatic payroll deductions and capture relevant details.
  5. Sign the paperwork and utilize a certified notary signing agent if necessary.

What To Include in Employee Loan Documents

Similar to the initial setup of a personal loan, employee loans should include these elements:

  • Covenants: Contractual conditions in a formal debt agreement
  • Guarantees: The people or person responsible if the borrower defaults
  • Interest rate terms: The annual percentage rate (APR) of interest charged
  • Repayment duration: A clear outline of the loan repayment period and the number of installments
  • Default terms: A clear plan for late fees, outstanding debt collection, and costs associated with collecting said debt
  • All parties involved: The business's name, the employee who is taking out the loan, and a witness.
  • Relevant dates: The dates all parties signed the agreement and when it goes into effect
  • Signatures: Capture and record the employee borrower’s signature and those of witnesses present during the signing.

Important Considerations Before You Loan Money to Employees

Take time to consider all angles before lending cash to workers, to avoid headaches down the road.

Loan Amount

What kind of hardship is a good enough reason for a loan? How much debt can this employee take on right now? Will the amounts offered be based on a percentage of the employee's income, employment status within the company, or some other factor?

Repayment Terms

Loan payments can be deducted from the employee's salary or paycheck and alternate payment methods can be set up before their employment status changes. The goal is to receive timely payment or avoid the employee absconding without fulfilling their agreement.

There are laws against paycheck deduction to repay an employee loan in some states, and paycheck deductions can’t reduce the employee's hourly pay below the national minimum wage of $7.25 per hour and must be authorized in writing. Check applicable state laws and regulations before enacting this method.

Default Terms

Does the company demand full settlement immediately, or create new terms to complete the loan repayment if an employee resigns? What happens if their employment is terminated, they default on the loan, or their hours are reduced?

Other Important Considerations

Ensure all parties involved understand the loan agreement terms, and keep organized records and bookkeeping documents for tax purposes. Companies may elect to require collateral, but this is rare. Consult your company's legal team if you want to include a clause that ensures the debt follows the borrower even if they leave.

Use payroll tools to automate this process for you. Many business financial software programs include templates for loan agreements that can be used for this purpose.

Employee Loan Alternatives

Other ways to assist your employees financially include offering paycheck advances, retirement plan loans, and recommending personal credit options.

Paycheck Advances

A paycheck advance is a temporary short-term cash loan given to an employee and repaid with the borrower's next paycheck. The benefits of paycheck advances are they are easier to obtain than loans, as long as the employer is amenable to it, and they can also provide short-term relief for cash-flow problems.

Retirement Plan Loans

Retirement plan loans are popular ways for employees to borrow against their retirement savings. One downside is that the IRS does require employees to repay a plan loan within five years and make payments at least quarterly, unless you use the funds to purchase a primary residence.

Personal Lines of Credit

Personal lines of credit are not as costly as traditional loans, lower risk than credit cards, can have a lower interest rate, and don't require collateral because they are unsecured lines of credit. A relevant factor to consider is that if the borrower's employment status changes adversely, it could be challenging to make on-time monthly payments, which will incur costly fees, higher interest rates, and tank their credit.

Discourage employees from taking out payday loans from private lending businesses by informing them of the financial risks and repayment difficulties due to astronomical interest rates often associated with these loans.

The Bottom Line

The process of lending your employees money can be a double-edged sword. It can be a great way to show your employees that you care about them and their financial needs, but there are risks involved that may negate both parties' benefits. Each situation will differ, so it's vital to have policies in place before money ever changes hands.

One of the most important things to consider before lending money to your employees is whether or not this is the best option for their financial situation. Will they be able to pay back the loan in full and in a timely manner? If it looks like they won’t be able to and you are unwilling to take this risk, explore alternatives to find a more sustainable solution.

Frequently Asked Questions (FAQs)

How should an employer report employee loans that are forgiven?

The IRS considers loans forgiven if the creditor agrees to cancel all or part of the debt owed. There are two ways that an employer can report the employee's debt forgiveness. The first way is to report it as a reduction in earnings, and the second is to report it as non-taxable loan repayment.

What is the market rate for employee loans?

According to Freddie Mac, the market rate for fixed-rate mortgage (FRM) and adjustable-rate mortgage (ARM) personal loans is currently 4.42% and 3.36%, respectively. Companies typically offer employees loans between 3% to 5% APR, which is quite reasonable compared to traditional private loan rates that average around 13%.

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