Many employees in the United States live paycheck to paycheck and are concerned not only about paying their monthly bills but also covering unexpected expenses. This financial stress can negatively affect businesses via lost productivity, reduced engagement and increased healthcare costs.
Employers can stem the tide with financial wellness services and give themselves a distinct recruitment and retention advantage over competitors. Basic services usually consist of retirement savings plans and financial counseling. Comprehensive financial wellness programs go further to help employees when unforeseen expenses occur and might include earned wage access and employee loans.
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What is an employee loan?
An employee loan or payroll deduction loan is money lent by employers to someone who works for them. It’s similar to a personal loan, except the interest rates are usually less than what a bank might offer.
This benefit can help employees cover financial emergencies or make personal purchases that add fulfillment to their lives. Specific eligibility requirements and loan terms vary by employer. Some consider the practice too risky and don’t offer payroll deduction loans.
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Key factors to consider for employee loans through payroll
It’s usually best to have an official stance on employee loans before someone asks for one. Employers who decide to make this benefit part of their financial wellness program may want to take the following steps when drafting policies:
- Determine eligibility
Offering a loan to one employee and not another could potentially lead to a discrimination lawsuit. To avoid such a risk, employers should determine the circumstances in which they will grant a loan. The employee’s length of service, current financial status and credit score might all play a deciding factor. - Establish loan terms
Like a financial institution, employers should dictate the minimum and maximum amount of financing available, the term length, how the loan will be repaid, and the amount of interest charged, if any. Interest rates must comply with the Applicable Federal Rates (AFRs). - Document records
Keeping accurate records of all money lent to employees and the repayment terms can help employers avoid tax law violations and may be useful in an audit.
How payroll deduction loans work
One of the more common ways for employees to pay back loans to their employers is through automated payroll deductions. The Fair Labor Standards Act (FLSA) permits this practice with the following caveats:
- Deductions applied to the loan’s principal may reduce the employee’s wages below the federal minimum wage.
- Interest and the administrative costs associated with the loan may not be deducted if it results in the employee earning less than the federal minimum wage.
State laws may differ from the FLSA. For example, some states prevent payroll deduction loans from reducing an employee’s earnings below minimum wage. In addition, most states require employers to first obtain employee consent before deducting loan dues from payroll; others do not.
Types of employer loans to employees
There are generally two kinds of loans for employees. Employers have the option of either:
- Working directly with employees and financing the loans themselves.
- Partnering with a third-party financial institution to provide affordable loans as an employee benefit.
The pros and cons of payroll deduction loans for employees
As much as employees might need financial support, lending them money may not always be the best option. It’s important for employers to weigh the pros and cons of loans through payroll deduction:
Pros
Granting employees a loan to alleviate their financial stress can help improve their engagement and productivity at work. It also sends a message that employers care about the well-being of their workers. Current employees may feel compelled to stay with the organization, and more people might want to join as a result.
Cons
Employee loans can strain a business’s finances, especially when multiple employees apply for them and qualify at the same time. This problem is compounded if an employee leaves the organization before the loan is repaid. The employer may have difficultly recovering the remaining balance and could suffer a loss.
Payday loan alternatives
Some employers might decide that employee loans are too great a risk for their business and that’s ok. There are other ways to improve employee financial wellness. Options include:
- Financial education, including how to budget, save money and reduce and prevent debt
- Loan consolidation opportunities to help pay off student loans, medical bills and other debt
- Tools and resources for budgeting and tracking income and spending
- Flexible pay options that allow employees to choose how they receive and manage their pay
- Home purchase advice and mortgage assistance
- Access to financial planning experts who can advise on investing
- Tuition reimbursement programs for employees who want to pursue a degree in related fields
- Robust retirement plans with employer-matching contributions
Frequently asked questions about loans for employees via payroll deduction
What is the difference between a payroll loan and an advance?
Payroll advances are usually limited to what an employee earns each pay period and are repaid within a few payroll cycles. Employee loans, in contrast, finance larger sums of money over a longer period of time.
What to include in an employee loan agreement?
Official loan agreements can help minimize some of the risks involved with lending employees money. These loan documents should be drafted with legal counsel and include at minimum:
- The names of the financier and employee
- The date the loan is signed and the date it takes effect
- Repayment terms and interest rates
- Employee and witness signatures
This article is intended to be used as a starting point in analyzing loans based on employment and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.
