Methods of calculating minimum interest rates

Hello,

I've seen various methods used for the calculation of interest rate on 401(k) loans, but am not sure what part of the code specifically addresses this.  Anecdotally, I have seen rates in plans such as 'WSJ Prime plus X%, or even using the rate of G funds for a TSP.  If anyone could point me to guidance on this it would be helpful. I'm looking to set a rate that is as low as is appropriate while maintaining proper boundaries on how low the number can be.

There's nothing in the code or regs except something about it being reasonable and maybe what another lender might charge; I don't even remember it's been so long and I have blocked those thoughts from my head.  I think you are safe between prime and prime plus 2%.  My guess is a plurality use prime plus 1%.

In 2011, the IRS and a phone forum that suggested that prime or prime +1 might not pass muster as "reasonable."  Here is the transcript:

https://www.irs.gov/pub/irs-tege/loans_phoneforum_transcript.pdf

However, in the intervening 8 or 9 years, I have yet to hear about anyone getting in trouble for prime +1.

33 minutes ago, BG5150 said:

In 2011, the IRS and a phone forum that suggested that prime or prime +1 might not pass muster as "reasonable."  Here is the transcript:

https://www.irs.gov/pub/irs-tege/loans_phoneforum_transcript.pdf

However, in the intervening 8 or 9 years, I have yet to hear about anyone getting in trouble for prime +1.

Nor have I.

I agree with the above commenters but would add that we use prime + 1 with a minimum of 6%. Thought process being that the participant should be able to recoup to him/herself approximately what he/she might have earned in the market. Actually had an regulatory agency comment once that low rates could be seen as detrimental to the participant.

The government agencies have never provided much helpful guidance.  The IRS has said in a number of forums over the years that prime plus is not commercially reasonable but many, many loan programs use it.  A commercially reasonable rate is required.  One comparable type of loan is the compensating balance loan which often is discounted.  I have heard IRS presenters say the rates from these loans were too low.  

On 4/28/2020 at 1:00 PM, Bird said:

There's nothing in the code or regs except something about it being reasonable and maybe what another lender might charge; I don't even remember it's been so long and I have blocked those thoughts from my head.  I think you are safe between prime and prime plus 2%.  My guess is a plurality use prime plus 1%.

We use prime plus 1%. Had a phone conversation on an audit today involving loan; auditor LOVED that we used prime plus one.  It was nice to hear.  I disagree with IRS that prime is not reasonable. We are talking about a 100% secured loan; and I can borrow from my bank on my line of credit today at less than the prime rate which is 3.25%.  A loan issued today would be a 4.25%.  NO PROBLEM.  IRS (or DOL) could never make a claim stick that that number is not reasonable for a 100% secured loan (which is effectively a "passbook loan" type of transaction).
 

Some commentary from Bankrate website on passbook loans (especially note highlighted item); you can find the link here:

https://www.bankrate.com/loans/personal-loans/passbook-loans/

Terms and conditions vary widely. You’ll continue earning interest on the portion of savings that’s being borrowed, and as you repay the loan you’ll have access to those funds. Some banks lend 50% of the account balance; others let you borrow up to 100%. A common interest rate seems to be 3% above the interest rate being paid on the savings.

“Typically they’re earning 1% on the deposit account. So, we’re loaning out at 4% and making 3% with no loss experience,” says Connie Cesario, vice president at Citizens-Union Savings Bank in Fall River, Mass.

At Workers Federal Credit Union in Stafford Springs, Conn., there’s a tiered rate tied to the percentage of the loan that’s secured by savings.

“If they use savings to back the whole loan, the rate is 3%,” says Betty Maurer, president and CEO. “If they secure just part of the loan with their shares they pay a higher rate. If they secure 25%, they’d pay 7% interest.”

I seem to remember that phone forum causing a bit of an uproar at that time and the IRS backtracking a bit on that calling informal guidance or something like that?