Facts
A participant in our 401(k) plan took out a loan a couple years ago. She could only afford to make the bare minimum payments at the time, but is now in a financial position to pay down the loan more quickly.
Question
Is it alright for a participant to make extra payments on his or her loan in order to expedite pay-off?
Answer
It is theoretically possible for a participant to make extra payments on a 401(k) loan, but trying to implement that can be somewhat impractical.
The first order of business is to check your plan document and loan policy to see what it says. Many are written to say that pre-payments are only allowed if the loan is being repaid in full. In other words, it would not be allowed to pay a little extra here and there. In that situation, the participant could set aside the extra in a savings account or something like that. When he or she has accumulated enough, the loan could then be repaid in full.
Another thing to check is whether plan documents require that payments be made via payroll deduction. If so, the only way a participant could make additional payments would be to adjust withholding on the applicable paychecks. That, of course, is possible, but it could certainly cause administrative headache.
If the plan documents do not contain that type of limitation, the second step is to find out what the plan’s record keeper can accommodate in terms of applying the extra payment amount. With the typical loan, additional amounts paid over and above the regular periodic payment are applied to the principal balance of the loan. Not only does that reduce the outstanding balance, but it also reduces future interest accruals.
Many 401(k) record keeping systems, however, are not able to deviate from the amortization schedule that was created at the beginning of the loan. In those cases, the common practice is for the record keeper to hold the extra amounts and apply them to regularly scheduled future payments.
As an example, let’s assume I have a loan with semi-monthly payments of $50 each. On June 1, I triple-up and send in payments of $150. Rather than applying $50 to my regularly scheduled payment and the remaining $100 as a reduction in principal, the record keeping system simply applies the $150 so that it covers the next three regularly scheduled payments. My loan does not get paid down any faster, and I do not save any interest. If there is no savings and the loan is not being paid off any faster, a participant probably will not be as inclined to make additional payments.
So, the answer is not “no," but this is one of those cases where a “yes” answer isn’t all it’s cracked up to be.
For more information on qualified plan compliance, visit our Knowledge Center.
