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# Loan Payment

The loan payment formula is used to calculate the payments on a loan. The formula used to calculate loan payments is exactly the same as the formula used to calculate payments on an ordinary annuity. A loan, by definition, is an annuity, in that it consists of a series of future periodic payments.

The PV, or present value, portion of the loan payment formula uses the original loan amount. The original loan amount is essentially the present value of the future payments on the loan, much like the present value of an annuity.

It is important to keep the rate per period and number of periods consistent with one another in the formula. If the loan payments are made monthly, then the rate per period needs to be adjusted to the monthly rate and the number of periods would be the number of months on the loan. If payments are quarterly, the terms of the loan payment formula would be adjusted accordingly.

### Standard Loan Payment

The loan payment formula shown is used for a standard loan amortized for a specific period of time with a fixed rate. Examples of specialized loans that do not apply to this formula include graduated payment, negatively amortized, interest only, option, and balloon loans.

An adjustable rate loan will use the formula shown but will need to be recalculated based on the remaining balance and remaining term for each new rate change.

#### Use of Loan Payment Formula

The loan payment formula can be used to calculate any type of conventional loan including mortgage, consumer, and business loans. The formula does not differ based on what the money is spent on, but only when the terms of repayment deviate from a standard fixed amortization.

Simple interest and amortized loans will generally have the same payment. The terms amortized and simple interest relate to how much of the payment is applied to principal and how much is applied to interest for each payment.

Simple interest loans rely on the date of payment to determine the amount of interest paid with the remaining amount going to principal. If a payment is made early, the interest portion of the payment will be less than if paid later. Less interest accrues when the amount is paid early because the loan balance will be less due to the extra principal payments.

On the other hand, an amortized loan has a predetermined amount of interest paid per payment so an earlier payment has no affect on lowering the principal balance sooner. Different companies and their loans will have different policies on how they are amortized. An example of how a company may amortize their loan, is by re-amortizing every year so that extra principal payments to the loan will only go in effect after a year to lower the monthly interest portions of the payment.

##### Alternative Loan Payment Formula

The payment on a loan can also be calculated by dividing the original loan amount (PV) by the present value interest factor of an annuity based on the term and interest rate of the loan. This formula is conceptually the same with only the PVIFA replacing the variables in the formula that PVIFA is comprised of.

# How do I Correct a 401(k) Plan Loan Error?

Many 401(k) plans allow loans to participants. However, failure to properly administer plan loans is a common 401(k) compliance issue. Before distributing loans to participants, plan sponsors should ensure that their plan document: (i) allows plan loans and (ii) appropriately reflects the requirements prescribed under Internal Revenue Code (the “Code”) Section 72(p).

What are the loan requirements under the Internal Revenue Code?

In order to avoid treatment of a loan under a 401(k) plan as a taxable distribution, such loan must satisfy certain requirements under Code Section 72(p) including:

1. The loan must be a legally enforceable agreement.The agreement can be a paper or electronic document stating the date and amount of the loan. The agreement must bind the participant to a repayment schedule.
2. The amount of the loan cannot be more than 50% of the participant’s vested account balance up to a maximum of \$50,000.If the participant previously took out another loan from the 401(k) plan, the \$50,000 limit is reduced by the highest outstanding loan balance during the one-year period ending on the date before the new loan.
3. The loan agreement must require the participant to make level amortized payments at least quarterly.Each repayment should include an allocation of principal and interest. Generally, a 401(k) plan loan must be repaid within five years unless the participant uses the loan to purchase his or her main home.
4. Exception for leave of absence. Code Section 72(p) provides an exception to the loan repayment schedule for participants who take a leave of absence. The 401(k) plan may suspend a loan for one year while the participant is on a leave of absence. However, the 401(k) plan may not extend the loan’s maximum five-year repayment period. Upon return from leave of absence, the participant must ensure repayment within the maximum five-year repayment period by either: (i) increasing the payments over the remaining term of loan, or (ii) making a catch up payment for the missed payments during the leave of absence.

What are the correction procedures for a 401(k) plan loan error?

It is important that 401(k) plans have a system in place to ensure that the terms of a participant loan and its repayments follow the requirements under Code Section 72(p) so that the loan is not treated as a taxable distribution. The most common 401(k) plan loan and correction requirements are as follows:

1. Loan that exceeds the dollar limit. The participant must repay the excess loan amount and amortize the remaining principal balance (if any) as of the repayment date over the original loan’s remaining period.
2. Loan that exceeds the maximum loan period.The outstanding amount of the loan is reamortized over the maximum remaining period allowed under Code Section 72(p) (5 years) from the original loan date.
3. Loan that is in default because of failure to make timely payments. The participant must either:
• Make a lump sum payment for the missed installments (adjusted for interest);
• Reamortize the outstanding balance of the loan, resulting in higher payments going forward; or
• A combination of a make-up payment and reamortization of the loan.

The plan administrator can preserve the tax exemption for a 401(k) plan loan in certain circumstances. The plan administrator may allow for a “cure period” that would permit a participant to make up for a missed payment. The cure period cannot go beyond the end of the second quarter following the quarter in which the missed payment was due. If the loan violated the terms of the 401(k) plan document or Code Section 72(p), the plan sponsor can either: (i) use the Voluntary Correction Program (VCP) to permit employees to include the amount of loan in income in the year of correction, or (ii) request relief from reporting the loans as taxable distributions to participant under the VCP.

This summary is intended to be informational and does not constitute legal advice. Hamby Benefits Law, LLC recommends that you consult ERISA legal counsel to assist (i) in reviewing 401(k) plan documents to ensure compliance with the requirements for loans under Code Section 72(p), and (ii) with administration and implementation of correction procedures in the event of a 401(k) plan loan error.