mortgages direct vs indirect amortization

Direct vs. Indirect Amortization of Mortgages in Switzerland

Amortizing a mortgage by pledging retirement savings to the lender and settling payment upon reaching legal retirement age is popular in Switzerland. Get an overview of the pros and cons of indirect amortization in this moneyland.ch guide.

When you mortgage a home in Switzerland, you can choose from two methods of amortization. The standard model is direct amortization, which involves making regular repayments to the lender to pay off your loan. The other option is indirect amortization, which involves making regular contributions into a 3a account, 3a whole life insurance policy or 3a retirement fund and pledging those pillar 3a retirement assets to the mortgage lender.

Banks may require that you hold your 3a assets in their own 3a retirement accounts in order to qualify for a mortgage from them, but this is not always the case.

Advantages of direct amortization of mortgages

Lower interest costs. Interest is charged as a percentage of your outstanding debt multiplied by the amount of time during which you carry that debt. When you directly amortize your mortgage, the interest charged decreases steadily over time.

Example: You mortgage a home for a 500,000 Swiss franc home loan with a 1% annual interest rate and a 20,000-franc annual amortization payment. You pay 5000 francs in interest the first year (1% of 500,000). The second year you pay 4800 francs in interest (1% of 480,000) because you have paid off 20,000 francs of your debt. The third year you pay 4600 francs in interest (1% of 460,000) because you have paid off 40,000 francs of your debt. Over the 25-year amortization term, you would pay 65,000 francs in interest.

Disadvantages of direct amortization of mortgages

Higher taxes. In Switzerland, mortgage interest charges can be deducted from your taxable income. The higher the interest payments you make, the lower your taxable income will be. Mortgage debt can be deducted from your taxable wealth for wealth tax purposes. Paying off your debt through direct amortization reduces the interest charges and the loan principal, resulting in lower tax deductions.

Advantages of indirect amortization

Lower taxes. When you use a 3a retirement saving solution to indirectly amortize your mortgage, you enjoy direct tax benefits. Money paid into a 3a retirement account can be deducted from your taxable income up to the annual legal limits for employed and self-employed individuals. That means you can deduct at least part of your amortization payments from your taxable income. Assets held in 3a savings solutions are not subject to wealth tax. Another major tax benefit is that you can deduct interest charges on debt from your taxable income – up to certain limits, and mortgage debt is deducted from your taxable wealth when calculating wealth tax. So, carrying mortgage debt rather than amortizing it can result in your paying lower taxes.

Note that your 3a assets become taxable upon withdrawal, and that needs to be taken into account when calculating the tax benefits of indirect amortization. A special rate equal to 1/5 of the regular income tax rate applies in the case of federal income tax. Cantonal income taxes vary. In every case, you pay lower income tax on these assets than you do on income which is not channeled through a 3a savings solution, as would be the case with the money used for direct amortization.

Disadvantages of indirect amortization of mortgages

Higher interest costs. When you amortize a mortgage indirectly, the money which will be used to pay off your mortgage sits in a 3a account until you reach the age at which your assets can be withdrawn (5 years ahead of legal retirement age). Because the debt is not paid off over the mortgage term, you pay the full annual interest every year in the term.

Example: You mortgage a home for a 500,000 Swiss franc home loan with a 1% annual interest rate and a 20,000-franc annual amortization payment (paid into a pledged 3a account). You pay 5000 francs (1% of 500,000) in interest every year over the 25-year term, or a total of 125,000 francs in interest – almost double the interest you would pay using direct amortization.

While you do earn interest on assets held in a 3a retirement savings account, this interest is generally lower than the interest you pay for your mortgage. Over time, the difference between the interest which you earn on 3a savings and the higher interest you pay for your mortgage can add up to a significant amount of money. You can minimize this disadvantage by claiming your legal right to withdraw 3a assets for the purchase of a primary residence every 5 years, and using the money to amortize your mortgage. Withdrawing the 3a savings to make mortgage amortization payments every 5 years as allowed by Swiss law helps to minimize the cost of interest by reducing your mortgage debt.

Less 3a retirement savings. Annual limits on the amount of money which can by contributed to the 3a category are relatively low, especially for employees who subscribe to a pension fund. If you tie up all or most of your pillar 3a allowance in a mortgage, you will not be able to effectively use this category for retirement saving. Closing any possible gaps in your Old Age and Survivors Insurance (OASI) and occupational pension fund (pillar 2a) can help to balance the absence of 3a retirement savings. Using non-tax-privileged retirement saving solutions (pillar 3b solutions, for example) to compensate for the absence of 3a retirement savings nullifies part of the tax benefit of indirect amortization because while you save taxes on your mortgage, you pay taxes on your retirement savings.

Usage limitations. Tax-privileged 3a assets can only be used to amortize your primary residence. You cannot indirectly amortize a secondary residence (a holiday home, for example) using indirect amortization.

Conclusion

Whether direct or indirect amortization is the best solution for you depends primarily on your tax situation and how your taxes compare to total interest charged on your mortgage. If you already claim a lot of tax deductions and the tax savings you could get are lower than the amount which you would spend on mortgage interest, direct amortization may be the better solution. If your taxes are high, the tax benefits of indirect amortization can make up for the extra interest you pay by carrying your mortgage debt.

More on this topic:
Swiss mortgage comparison
3a retirement account comparison

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