Retirement News for Employers - Winter 2012 - Participant Loans – What is a Reasonable Interest Rate?
When a retirement plan allows participant loans, that loan is an investment of plan assets and must bear a reasonable rate of interest.
According to the Department of Labor, a plan’s loan interest rate is reasonable if it is equal to commercial lending interest rates under similar circumstances (DOL Regulations section 2550.408b-1(e)).
To determine if a participant loan interest rate is “reasonable,” ask these questions:
- What current rates are local banks charging for similar loans (amount and duration) to individuals with similar creditworthiness and collateral?
- Is the plan rate consistent with the local rates?
The DOL Regulations give several examples of how to determine a reasonable rate of interest for a plan loan.
Example 1: Plan P makes a participant loan to A at the fixed interest rate of 8% for 5 years. The trustees, prior to making the loan, contacted two local banks to determine under what terms the banks would make a similar loan taking into account A's creditworthiness and the collateral offered. One bank would charge a variable rate of 10% adjusted monthly for a similar loan. The other bank would charge a fixed rate of 12% under similar circumstances. Under these facts, the loan to A would not bear a reasonable rate of interest because the loan did not provide P with a return commensurate with interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances. As a result, the loan would fail to meet the requirements of section 408(b)(1)(D) and would not be covered by the relief provided by section 408(b)(1) of the Act.
Example 2: Pursuant to the provisions of plan P's participant loan program, T, the trustee of P, approves a loan to M, a participant and party in interest with respect to P. At the time of execution, the loan meets all of the requirements of section 408(b) (1) of the Act. The loan agreement provides that at the end of two years M must pay the remaining balance in full or the parties may renew for an additional two year period. At the end of the initial two year period, the parties agree to renew the loan for an additional two years. At the time of renewal, however, A fails to adjust the interest rate charged on the loan in order to reflect current economic conditions. As a result, the interest rate on the renewal fails to provide a “reasonable rate of interest” as required by section 408(b)(1)(D) of the Act. Under such circumstances, the loan would not be exempt under section 408(b)(1) of the Act from the time of renewal.
Example 3: The documents governing plan P's participant loan program provide that loans must bear an interest rate no higher than the maximum interest rate permitted under State X's usury law. Pursuant to the loan program, P makes a participant loan to A, a plan participant, at a time when the interest rates charged by financial institutions in the community (not subject to the usury limit) for similar loans are higher than the usury limit. Under these circumstances, the loan would not bear a reasonable rate of interest because the loan does not provide P with a return commensurate with the interest rates charged by persons in the business of lending money under similar circumstances. In addition, participant loans that are artificially limited to the maximum usury ceiling then prevailing call into question the status of such loans under sections 403(c) and 404(a) where higher yielding comparable investment opportunities are available to the plan.
What are the consequences of not using a reasonable loan interest rate?
Unless a reasonable rate of interest is assessed, participant loans may result in a prohibited transaction (see DOL Regulation section 2550.408b-1(a) and Internal Revenue Code section 4975(c)(1)(B)).
As a result, the loans would not:
- meet the requirements of ERISA section 408(b)(1)(D);
- be covered by the relief provided by ERISA section 408(b)(1); and
- meet the prohibited transaction exemption for participant loans in IRC section 4975(d)(1).