First of all, a loan is a loan. A liability. Yes, you can argue that there are good loans and bad loans, the ones which you take to invest in some asset including your own development that would pay returns in the future vis-a-vis the ones you take for entertainment and travel which are nothing but just blowing up money without any returns. I take your point, but still…loans are loans and even good loans can turn bad and cause financial distress. How can good loans go bad? Here are a few examples:
- When loans are not permitted:
You might be applying for a loan which is categorized as good and maybe plans are not required to start with. But one must be sure that the necessary provisions for loan approval are included in the plan. Plan sponsors might be just approving your plan without taking the effort to see to the amendments required in it. However, issuing a loan where in reality the plan does not allow it can turn into a bad loan since the loan amount is immediately deemed as distributed.
- When refinancing of a loan is not permitted:
Many a times home owners wish to change or modify their loan or get it refinanced. Not all plans permit refinancing and also most of the times the inability to refinance is also not very clear. Long story short, when refinancing does not get permission, your good loan might just turn into a bad one.
- Duration of Loan Term:
If the amortization of a loan goes on for more than what it was permitted then it becomes a bad loan by default and the entire loan amount is a deemed distribution. For example, if a plan issues a loan for more than 5 years, and that is anyway the regulatory limit, then this defect cannot be solved by plan amendment for longer amortization. However, if a plan chooses to limit all loans to 5 years and then issues a particular loan, let’s say a residential loan for more than that duration,than there is scope for plan amendment.
- Non-started Payments:
Sometimes a loan is taken that would be repaid later on by regular deductions form payroll. Common example would be an educational loan. However, lets say, the payroll system was not set up or it somehow does not deduct the same. So the loan goes to default. This does not make the entire loan amount defective though, the payer has till the end of the period to make it up to date to avoid deemed distribution.
- Payments discontinued:
Lastly, in some circumstances, when a person can no longer afford to make loan payments he/she asks the company to stop with holding, either on a temporary or a permanent format. The company might or might not abide by the request. Even if they do in order to help out its employee, the loan is very much default and might become a deemed distribution. Even though loan takers borrow from his/her own account balance, but for the loan plan, it is still an asset. So by voluntarily discontinuing, the plan is basically failing to ensure the pre-determined legal agreement between the plan and the borrower, reducing the plan asset to decrease in value.
So for all the above cases we see how a good loan may turn into abide one. Hence financial education and thereafter financial planning is crucial to avoid loans in the first place and even if going for a loan, to take into consideration all that which might suddenly turn it into a bad one!