Direct or indirect amortization – how do I decide?
Unlike in many countries, including our French neighbors, in Switzerland mortgage loans are not repaid in full. Financial institutions usually demand the amortization of only part of the debt. For this, borrowers have the choice between two main types of amortization – direct or indirect. Resolve will provide you will a few definitions to help you make this strategic decision.
How much will I have to amortize?
Mortgage loans are divided into sections: the first and the second parts. This split depends on how the various lenders interpret FINMA directives. The amount of the first part varies according to the type of housing guaranteed by a mortgage loan.
For example, for a property that the lender considers to be “normal” (accommodation on a market where offer and demand are more or less equal), the debt will usually be distributed as follows:
- 1st part: up to 65% of the property’s value
- 2nd part: between 65% of the property’s value and the total amount of the debt
Example of a financing breakdown for a "normal" property with an 80% loan
For a mortgage loan where the property that serves as guarantee is considered more “at risk”, a luxury mansion or castle, for example, the 1st part will be limited to around 50% of the property’s value.
Only the second part must be amortized; for a “normal” property, only 15% of the value of the real estate. If your loan is inferior to the amount of the first part set by the lender, you have, therefore, nothing to reimburse.
The duration of the amortization of the second part may also vary from one institution to another. It is usually 15 years. In all cases, the loan must be amortized up to the first part by the legal retirement age of the borrower.
Why is it advantageous not to amortize all of the debt?
Only amortizing part of the debt provides borrowers with a few advantages:
- The existing debt may be deducted from the borrower’s taxable wealth
- Mortgage interest is deductible from taxable income
- Borrowers can invest the sums saved in services with a higher yield than the current low interest rates.
It is, therefore, interesting to remain in debt to a high level and tax on rental value will enter into the calculations. Having tax deductible sums is a good way of counteracting this new tax.
This situation is also seen as good thing by lenders. It allows them to invest in mortgage loan services by taking calculated risks. Indeed, in the event of failure to pay by the borrower, it will be easy to resell the property, at least at the price of the first part.
That is why the first part is not set at the same level for all properties. They do not carry the same risk. During a crisis period, the value of a luxury property will fall more steeply in proportion to that of a traditional property. Consequently, the first part will be lower and, therefore, the share to be amortized will be higher for the former.
Once the amortization amount is known, those searching for credit have a strategic choice to make – whether to opt for direct or indirect amortization.
Direct amortization: the repayment goes directly to the lender
In this system, the depreciable part of the mortgage loan is repaid consistently every year to the lender. If we go back to the previous example, the 15% must be repaid in 15 years. The borrows must, therefore, repay 1% of the value of the property every year.
This reimbursement is in addition to the mortgage interest and maintenance costs to be paid in the monthly installments.
In the case of direct amortization, the amount of the debt is, therefore, reduced regularly and the mortgage interest is also reduced. The later is calculated by considering the interest rate multiplied by the remaining loan amount.
From a tax point of view, this solution is less ideal than it sounds. Indeed, mortgage interest is tax deductible. As it goes down, this advantage will also be reduced and will cease to counteract the tax on rental value.
Direct or indirect amortization?
In the case of indirect amortization, the borrower only pays the mortgage interest to the lender. The amount to be amortized every year is paid into a third pillar A and/or B life insurance policy. At the end of the period agreed with the lender, the borrower repays all, or part, of the depreciable share in one go. The borrower may also decided to continue amortizing until normal retirement age and then repay what they owe.
Indirect amortization is more advantageous for the borrower from a tax perspective. The amount of the debt remains constant and you keep deducting as much mortgage interest as possible.
Moreover, payments to a third pillar A are also fully tax deductible up to 6,883 CHF per year. And in the Cantons of Geneva and Freiburg, the premiums of the third pillar B are partially deductible. This means that another significant layer of tax deduction can be added for borrowers.
For indirect amortization via a third piller/life insurance, the objective is three-fold:
- covering the depreciable part of the loan,
- building private capital,
- covering the risk of death and freedom from paying premiums (the insurance pays the premiums instead of the borrower in case of invalidity until the contract term).
If the borrower needs cover, especially if one spouse’s salary dominates or if the borrower uses their pension assets to carry out their purchase, this solution appears more beneficial as it avoids mobilizing the sums twice.
Generally, indirect amortization makes more financial sense than direct amortization. The scale of this advantage often depends on potential tax savings. In other words, the higher the borrowers’ revenue, the more beneficial indirect amortization is.
Furthermore, if you opt for indirect amortization and, at the term set by your contract, your property has increased in value, it is possible that you will not have to repay the original depreciable share.
Take the example of a property purchased for 800,000 CHF with a mortgage loan of 640,000 CHF and, therefore, a depreciable share of 120,000 CHF.
If, in 15 years, the fixed term for your amortization, the property has increased in value and is now worth 990,000 CHF, the existing loan of 640,000 CHF represents a little less than 65% of the new value of the property. There is, therefore, nothing left to amortize.
However, provision must be made so that the remaining debt at retirement age is bearable. Even if you no longer required to amortize it, it may be necessary for you to keep doing so anyway.
It is also possible to optimize indirect amortization by making direct, partial repayments at regular intervals. This lets you retain the advantages of indirect amortization while reducing the interest-related costs so that they are bearable in the long term.
We are here to help
In any case, there is, unfortunately, no magic recipe. Every project has its particularities and must be examined individually. At Resolve, our team of mortgage advisors work hand-in-hand with insurance and pension advisors, who are available to help you get to grips with this strategic decision. We do all we can to find the products that best suit your profile. Don’t miss this opportunity to get impartial support.
Simulate your project online or contact our teams to get started.