According to a survey by the American Management Society, around 79% of Americans live on paycheck to paycheck, and around 17% resort to their loved ones for financial help, making employee loans more common.
The question is how you support an employee if he or she asks for a loan. How you do it responsibly? Read on this article to learn what you should consider when granting loans to employees.
Employee loans are financial assistance provided by businesses to their employees. Just like a small business loan, employee loans usually carry interest rates and repayment terms. The interest rate includes the administering cost and employer tax liabilities. The repayment is made via deductions in employees’ future paychecks. These loans are considered an advance on future earnings of the employees.
Things to Consider When Offering Employee Loans
Employee loans are being offered as a benefit to employees and the employer should have transparent and detail policies and procedures laid out for the loan program. Here are a few things to consider when creating policies for your employee loan:
- The reasons for providing a loan should be clear. Whether it’s for financial assistance or any other reason. What should be included in the loan documentation? Is the employee eligible for an employee loan? What are the eligibility criteria?
- Since you cater to your employees’ needs, it’s better to ask them why they need money. Asking for financial assistance for a one-time emergency or an unanticipated event is OK, but continuous overspending may lead them to borrow repeatedly.
- Creating guidelines and formalizing employee loan program should be your next step. This is essential because if you offer a loan to one employee, others will ask as well.
- What will be the loan amount? Every employer should set aside a specific amount for the loan program. Is it going to be a fixed amount, or is it going to be a portion of the employee’s salary?
- What will be the term of the loan? Generally, these loans have shorter repayment terms ranging from two to three years. Longer repayment terms are harder for the employer to maintain a fund for loans. It will also become arduous if the employee leaves the company before repaying the loan. In addition, there are laws in some states’ that preclude the employer from recovering the loan.
- What will be the repayment method? Is it going to be a payroll deduction?
- If the loan amount exceeded $10,000, charge the Applicable Federal Rate (AFR) on interest. Non-charging of the interest rate will lead to taxation since the IRS will consider it as “phantom income”.
- Having a promissory note drawn up can be an intelligent step before issuing loans to employees. This will outline the loan’s terms such as repayment amount, frequency, interest rate, and what happens if the employee defaults. Consulting with a business attorney is recommended while setting up your employee loan program.
Benefits of Employee Loans
There are many reasons why your employee might need a loan. This includes debt, education, medical expenses, or even basic living expenses. With an employee’s loan program in place, it can help ease the financial stress so they can focus on their work. This not only eases the financial burden of your employees but also helps build loyalty and retention. Here are some benefits of employee loan for your small business:
- Lessening employees’ money woes – making them more productive at work. According to a study by the International Foundation of Employee Benefit Plans, 60% were unable to perform at work due to their financial hardships and 34% resulted in absence and unpunctuality.
- Foster loyalty and boost self-esteem within your company.
- Helps build solid business’s reputation as a company that cares about employees.
- Help drive more employee engagement and retention with low turnover.
- Eliminates the need for salary advances
- Server as a valuable recruitment aid
- Reduces 401(k) account borrowing
Drawbacks of Employee Loans
Regrettably, there are some downsides to employee loans as well. Some of the drawbacks may include:
- An added stress when repaying loans. Some employees might not make timely loan payments, or worse, not pay at all.
- If they are unable to pay back the loan, they might negotiate to increase the loan term or reducing the interest rate.
- Offering loans to one employee means preparing others to make loan requests as well.
- Increased in employer tax obligations
- Providing benefits costs more for small employers than for large ones, both in terms of higher prices because of lesser buying power, and due to relatively higher costs of administration.
- Less choice in drafting a retirement plan due to administrative costs.
- The more benefits you offer, the more you have to pay in terms of administrative costs.
- Providing financial benefits leads to legal compliance, making the company incur legal fees.
Alternatives Options to Employee Loans
If you’ve decided not to extend loans to your employees, there are some alternatives for financial aid that could help your employees when they needed financial assistance.
- Paycheck Advance
The first alternative to an employee loan is a paycheck advance being a simple solution when your employee is s hitting a financial rough patch. With a paycheck advance, you can reduce your business’s potential loss to the amount of one paycheck by providing your employees with some of their paychecks early. This is also an easy alternative to an employee loan especially when your employee needs short-term financial assistance.
- Retirement Plan Loans
A loan from an employee’s 401(k) can be another solution if your business offers 401(K) plans. In this plan, employees can borrow up to 50% against an account balance, up to $50,000. 401(K) plans charge a reasonable interest rate with repayment terms up to five years. Though, if an employee leaves your company, they will have to repay in full, else their unpaid balance will be considered as a taxable distribution.
- Third-Party Financial Apps
Another best approach is to inspire employees to use third-party apps like MoneyLion, Brigit, SpeedyCash, PayActiv, and Earnin. With these services, employees get an advance on their paycheck without any interest or fees. The process is simple: connect your bank account and add your employment info to help third party services identify your pay schedule. Add your income to the app by uploading an electronic worksheet to be able to borrow up to $100 daily from your pending paycheck.
Every small business considers its employees as extended family members, and it’s a norm to assist them especially when they’re facing financial hardship. As a business owner, only you can decide either it’s sensible to offer loans to your employees.
Before making a decision, evaluate how it will affect your business, your employees, and the entire workplace. Have you ever offered a loan to your employees? What was your experience with them? Share your experience in the comments below.