Participant Loan Refinancing

Posted by Maria T. Hurd, CPA

*Revised 4/20/17

Disclaimer: All blog posts are valid as of the date published.

ERISA Limited Scope AuditAdministrative simplicity or sympathy for participants in need? Allowing more than one participant loan in a retirement plan is not a black-and-white determination.

With the justifiable goal of administrative simplicity, most of our audit clients permit only one participant loan to be outstanding at a time, with no option to refinance. Every so often, an sympathetic plan sponsor who wants to help with its employees who need financing for reasons that don’t meet the hardship distribution requirements, endeavors to tackle the complexities of allowing two participant loans and/or offering participant loan refinancing. The rules can be tricky, but they are not difficult for those unafraid to take a couple of extra steps.

The loan requirements under Internal Revenue Code Section 72(p) still apply when a loan is refinanced:

  • The term of the loan must not exceed five years, unless the loan is used to purchase a principal residence;
  • Repayment schedule must provide for substantially equal payments made at least quarterly
  • There must be a legally binding promissory note
  • The amount of the loan (when added to the outstanding balance of all other loans) must not exceed the lesser of:
    1. $50,000, minus the difference between:
      1. The highest outstanding plan loan balance during the last twelve months, and
      2. The outstanding loan balance on the date the refinanced loan is made
    2. The greater of:
      1. ½ the vested account balance or
      2. $10,000 if additional security is provided for the excess over 50% of the account balance

Alternative 1: Combine loans and maintain the original repayment period

When one loan replaces another loan with a loan that is greater in amount if the repayment period of the replacement loan is within five years of the date the original loan was issued, the only thing that needs to be done is to compute the new level repayment amounts. That was easy, but the repayments would now be higher than they used to be, and the participant may not be able to afford them.

Alternative 2: Amortize two loans separately

The next easiest alternative, if the plan allows two loans to be outstanding at the same time, is to amortize the additional amount borrowed separately over five years and continue repayments of the original loan as originally scheduled. The total repayments for the two separately amortized loans would be higher than the original loan payment, but not as much as amortizing the combined loan over the original repayment period starting when the original loan was taken. That was also easy, but there is still a third choice.

Alternative 3:  Combine loans and repay over a new five-year repayment period

There is a way to effectively extend the original loan’s repayment period by treating it as a full repayment, immediately followed by a new loan. However, since the funding for the repayment comes from the same account balance, both the original loan and the replacement loan must be treated as if they were outstanding simultaneously, and the total amount cannot exceed the maximum available loan limits. This third alternative is not as easy as the first two, so let’s work through an example.

Example: Refinancing Participant Loans as a New Loan

If a participant with a $100,000 account balance takes a $10,000 loan on January 1, 2015 with a 5-year repayment period and 5% interest, the principal outstanding for the first three years is:

  • 1/1/2015 – $10,000
  • 1/1/2016 – $ 8,194
  • 1/1/2017 – $ 6,297

The maximum available loan balance as of January 1, 2016 is computed as follows:

Highest outstanding loan balance in the last 12 months $10,000
Subtract: Current outstanding balance  <8,194>
Difference $  1,806
Subtract the difference above from $<1,806>
The maximum available loan balance of   50,000
Reduced maximum available $48,194
Subtract current outstanding balance as of 1/1/2016 $<8,194>
Additional loan amount available $40,000


The participant is able to take the requested additional $10,000 loan.

To refinance the loans, both loans must be considered outstanding at once as follows:

Current balance $ 8,194
New loan ($10,000 + 8,194)  18,194


Since the sum of the two loan balances does not exceed the maximum available loan, the entire replacement loan can have a new 5-year repayment term.

Had the participant needed to borrow the entire $40,000 additional loan amount available, a new 5-year repayment term for the entire replacement loan would not have been an option.  The sum of both loans outstanding would exceed the maximum limit:

Current balance $ 8,194
New loan ($40,000 + 8,194)  48,194


In this case, the additional $40,000 borrowed could be amortized over the new repayment period and  the outstanding balance of the original loan, $8,194,  would continue to be amortized over the original 5-year period.

The wisdom of borrowing from a retirement plan account is a highly debated topic among financial advisors, and like everything else, the answer depends on many factors that do not have universal applicability. Is the participant loan replacing fixed income investments or taking dollars out of a rising market? Does the loan provide a fixed return in a declining market, giving the participant the opportunity to buy low with the repayments? Does the participant have no other source of financing? Each person’s situation is unique. Each plan sponsor also has a unique opportunity to offer multiple participant loans and/or refinanced participant loans. Whether additional loans should be offered might be a matter of opinion, but one thing is clear: if offered, the plan sponsor and its service providers must ensure that additional loans or refinanced loans are properly administered in accordance with the plan document and the loan regulations.

Photo by Lucas (License)