Employee Loans: Everything You Need to Know

Everyone knows that small business owners wear many hats—but most people don’t think that includes acting as a lender. However, given that 78% of American workers now live paycheck to paycheck, and only 17% of people can turn to a family member or friend for financial assistance, according to the American Management Society, employee loans are becoming more and more common.^[1] 

But if one of your employees asks for a loan, should you do it? And if you do extend loans to employees, how can you do it responsibly? There are a lot of variables to consider, which is why we created this guide.

Here is everything you need to know about employee loans, including what to consider when deciding whether or not to grant loans to employees.

What Is an Employee Loan?

An employee loan is money advanced by a business to assist an employee. Similar to personal and business lending, employee loans typically come with an interest rate and repayment schedule. However, employee loan interest rates are usually a small fee to cover the cost of administering the loan program, and any tax liabilities the employer may incur.

The employee pays back the loan in accordance with the repayment schedule typically via deductions in their future paychecks. In this way, employee loans can be looked at as an advance on future earnings by the employee.

Employee Loan Considerations

Employers offer loans to employees as a benefit to employees. As with any fringe benefit, the employer should have clear policies and procedures that detail the loan program. When creating your employee loan policies, here are some things you need to consider:

• Circumstances under which a loan will be granted: Will loans to employees be granted for any reason, or only for instances of financial hardship? Will any documentation be required in order to be granted a loan, such as an employee’s financial records? Is every employee eligible for a loan, or only those who have been at the company for a certain amount of time? These are questions you need to answer when creating your employee loan policy.
• Loan amount: If you are going to offer employee loans, set aside a specific amount to be used in the loan program. Also determine exactly how much you will lend to employees. You may want this to be a fixed amount, or a percentage of the employee’s salary.
• Loan term: Generally, employee loans have shorter terms of two to three years max. This is because it becomes hard to maintain a fund for loans if a loan is being repaid over a long period of time. Things also get complicated if the employee decides to leave your company before repaying the loan, as some states’ laws prevent the employer from recovering the unpaid loan amount.
• Repayment method: The most common repayment method for an employee loan is payroll deductions. However, check to make sure your state doesn’t have laws against this type of wage deduction.^[2]

When issuing loans to employees, it is important you have a promissory note drawn up. A promissory note is a document that spells out your employee’s promise to repay the loan. The promissory note will outline the loan’s repayment terms, including the payment amount, payment frequency, interest rate, and what happens if the employee defaults on the loan.

Because there are so many considerations when it comes to employee loans, we recommend consulting with a business attorney when setting up your employee loan program.

The Benefits of Employee Loans

Giving loans to employees might actually have some benefits for your business, including:

• Alleviating financial stress that makes your staff less productive because they’re worrying about money woes. In a study by the International Foundation of Employee Benefit Plans, 60% of respondents who feel financial stress said they were unable to focus at work as a result of their uneasiness and 34% said that financial stress increased their absenteeism and tardiness.^[3]
• Building loyalty and improving morale within a small business or office.
• Boosting your business’s reputation as an organization that cares about employees.
• Contributing to employee retention and reducing turnover.

Potential Problems of Employee Loans

Unfortunately, not all employee loan stories end well. Some of the problems you may run into include:

• Your employees might not make loan payments on time, or worse, not pay the loan back at all. And if they don’t pay it back, how large of an impact will it have on your business?
• They could try to negotiate terms if they’re still struggling financially, lengthening the loan term or reducing the interest rate.
• They may become “repeat offenders” with frequent requests to borrow more money if the reason for their loan request was caused by financial mismanagement. Just remember: You’re a business, not a bank.
• If you offer an employee loan to one staff member, you might have to prepare for loan requests from other employees, too.

Alternatives to Employee Loans

If you don’t want to extend loans to your employees, there may be a few alternatives that could help your employee when they need to borrow money.

Paycheck Advance

Chances are good that if your employee is asking you for a loan, they’re desperate. Maybe they’re faced with unexpected car repairs, medical bills for a family member, or even something like a surprise furnace replacement.

If that’s the case, a paycheck advance could be the answer. By giving your employees some or all of their next paycheck early, you limit your business’s potential loss to the amount of one paycheck, and it’s a simpler solution than a formal employee loan.

Retirement Plan Loans

Does your business offer 401(k) plans to your employees? If so, check into whether the plan is a “qualified plan” that might let participants borrow against their holdings. According to the IRS, in a qualified plan, “the maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.”^[4] Note that the employee will be charged interest on the loan, and the loan must be repaid within five years.

Use a Third-Party Service

Rather than create an employee loan program, encourage employees to use a third-party service like Earnin. With Earnin, employees can get an advance on their paycheck without being charged fees or interest. Simply connect your bank account and add your employment info to help Earnin recognize your pay schedule. Then add your earnings to the app by uploading an electronic timesheet. You’ll then be able to borrow up to $100 daily from your pending paycheck.

5 Things to Remember About Employee Loans

If you do decide to offer an employee loan program, it’s important to remember these five points to make sure everything goes as smoothly as possible.

1. Find out Their Needs

Ask your employee why they need the loan. Borrowing money for a one-time unexpected or emergency expense is one thing, but constant overspending and living without a budget may lead to a long road of being pestered to borrow more money.

2. Set Expectations

Formalize your lending arrangements to protect your business. Establish guidelines for your employee loan program, because chances are that if one employee gets a loan from you, others will ask.

3. The Promissory Note

Have your employee sign a promissory note. Include the loan’s details—like total amount—and repayment terms—like payment amount, payment frequency, interest rate, and what happens in case of default.

4. Keep Pristine Records

Make sure that any loans from your business are recorded “on the books” so loan payments made by your employee aren’t mistakenly identified as business income.

5. Your Interest Rate

If the employee loan given by your business is over $10,000, charge an interest rate of at least the Applicable Federal Rate (or AFR).^[5] This interest rate gets set by the IRS each month. If you don’t charge this interest rate, the IRS could consider your business as having received “phantom income,” which is taxable.

The Bottom Line

Small business owners often think of their employees as extended family members, and it’s hard not to sympathize when a family member struggles financially. Only you can decide whether it’s wise to extend loans to your employees.

Whatever you choose to do, think carefully about how your actions will impact your business, your employees, and the morale and work environment of your entire organization.

Article Sources:

1. CNBC.com. “The government shutdown spotlights a bigger issue: 78% of US workers live paycheck to paycheck“
2. Employmentlawhandbook.com. “Wage Payment Laws“
3. IFEBP.org. “2016 Survey Results“
4. IRS.gov. “Retirement Plans FAQs regarding Loans“
5. IRS.gov. “Index of Applicable Federal Rates (AFR) Rulings“