Loan Interest Rate - can it be too high?

[Guest ebailey]

Does anyone see an issue with setting the interest rate for a loan intentinally high such as prime plus 3% to discourage people from taking a loan? I realize the rate is supposed to be commercially reasonable rate - but there is next to no guidance as to what that actually means. Looking at various entries in this message board it appears that prime + 1 is the most common rate but is there anything to preclude a higher rate? Loans aren't a protected benefit so I can't come up with a reason that it couldn't be high.

any insights would be helpful.

thanks

[jpod]

I don't have an answer to your basic question ("what is a reasonable rate"), but my 2 cents is that, at least in today's credit environment and in view of the current prime rate, prime plus 3% is probably reasonable. However, you should also note that using a reasonable rate of interest is one of the conditions for the PT exemption under ERISA Section 408 and Code Section 4975, so it is more than just a tax-qualification issue.

[QDROphile]

Anecdotal evidence suggests that the IRS might assert that an excessive rate is a disguised contribution. Most at risk are individual or small professional plans.

[Guest ebailey]

thanks - never would have thought of that...

[rcline46]

Why discourage people from taking loans? Just amend the plan to remove loans, no more problems.

[Guest ebailey]

I wish the powers that be would agree to that...

[BG5150]

Why discourage people from taking loans? Just amend the plan to remove loans, no more problems.

Because a lot of times, the bosses will use their accounts as a sort of line of credit, but they don't want to have the hassle of doing it for the rank and file. So they keep the loan provision and try to keep it hush-hush.

As to prime+3: Here is what the ERISA Outline Book has to say about interest rates and the PT exemption:

2.d.Reasonable rate of interest must be charged. The plan must charge a commercially reasonable rate of interest. See DOL Reg. §2550.408b-1(e). The interest rate must be commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances.

Cross-reference tip. The Servicemembers Civil Relief Act of 2003 (SCRA) imposes an interest rate limitation on loans made to individuals who, subsequent to the origination of the loan, are called to active military duty. This limitation will supersede the interest rate requirement under DOL Reg. §2550.408b-1, since ERISA does not preempt other federal law unless preemption is expressly provided. For details on the SCRA interest rate limitations, refer to the discussion in Section IX, Part C.6.f., of Chapter 7.

2.d.1)Sampling of third party lenders' rates. Most plans administer this provision by reviewing a sampling of third party lenders (e.g., commercial banks) and the rates charged for similarly secured loans. Some plans use a formula tied to a commercially-recognized benchmark (e.g., 1% or 2% above prime rate in effect at beginning of the month), but the DOL will not give an opinion as to whether any particular benchmark is reasonable under the circumstances. Although plans that use this approach are generally not challenged by IRS auditors or DOL examiners, it is the responsibility of the plan administrator (or other fiduciary who is delegated this responsibility) to determine if the interest being charged by the plan satisfies the commercially-reasonable standard. 2.d.2)No safe harbor. The DOL regulations do not establish a safe harbor standard for determining commercially reasonable interest.

2.d.3)State usury laws. Limiting the interest rate to applicable state usury laws would not satisfy this requirement if the interest rate charged would otherwise not be commercially reasonable. See Example (3) in §2550.408b-1(e).

Preemption? The DOL has taken the position that ERISA preempts usury laws.

2.d.4)The Truth-In-Lending disclosure rules (Regulation Z under Title 12 of the Code of Federal Regulations) apply to a plan that has made more than 25 loans in the preceding year. The 25-loan threshold is decreased to 5 in the case of loans secured by a dwelling. ERISA does not preempt the Truth-In-Lending rules.