Amortization: pay off a mortgage or keep it?
Mortgage interest rates are extremely low at the moment. In the current situation, does it make sense to amortize a mortgage “in advance”? Anyone who has free liquidity should think carefully about this step. We explain below the most important criteria for opting for the voluntary amortization of a mortgage.
Mortgage amortization: meaning and conditions
Amortization means the repayment of debt in installments. The usual minimum standards of the Swiss Bankers Association (SBA) apply to Swiss banks: the mortgage must be reduced to two thirds of the purchase price within 15 years. To achieve this, the borrowers repay a constant amount each year or each quarter. This is mandatory amortization, which is also agreed by contract.
Extraordinary amortization is also possible. This varies depending on the property and the circumstances. In the case of long-term fixed-rate mortgages, extra repayments are not necessarily easily. The interest rate and the amount are usually fixed for the entire term. At the end of the term, the borrower is free to continue the existing mortgage or to reduce the amount. Other products such as Libor and SARON mortgages offer more freedom for extraordinary amortization.
Direct mortgage amortization
For every financing product, there is basically a choice between direct and indirect amortization of the mortgage: with direct amortization, the homeowner regularly pays back a constant amount. The mortgage decreases year by year as a result. This also reduces the financial burden in terms of mortgage interest.
Indirect mortgage amortization
As the name suggests, indirect amortization does not reduce the loan amount. The homeowner pays amounts into the 3rd pillar instead. The assets in this retirement savings account offer tax benefits and can be used for retirement planning or for purchasing owner-occupied residential property. This sum is pledged to the bank and is available for direct amortization later on.
With direct amortization, the tax-deductible interest decreases and the tax burden on the homeowner increases. In contrast, indirect amortization of the mortgage offers tax benefits: the mortgage interest is fully deductible from taxable income because the mortgage remains unchanged.
How mortgage amortization is calculated
The specific calculation of a mortgage can be seen from a case study of Claudia and Peter Muster: they bought their own house in the countryside ten years ago. The property cost 900,000 francs. The young couple with two children contributed 180,000 francs of equity. Key data for calculating amortization:
- Purchase price of the property: 900,000 francs
- Initial mortgage amount: 720,000 francs (80 percent of the purchase price)
- Objective after 15 years: 600,000 francs
- To be amortized in 15 years: 120,000 francs
- Annual amortization: 8,000 francs
Calculation of objective after 15 years: 900,000 * 2/3 = 600,000 francs
Amortization amount per year: 120,000 / 15 years = 8,000 francs
Imputed rental value: don’t forget the tax
Tax aspects must be taken into account to determine the optimal amortization strategy. The owner must of course pay tax on the imputed rental value of their property as income. Depending on the level of income and depending on progressive taxation, voluntary amortization of the mortgage may prove to be a disadvantage. Some homeowners therefore choose to keep their mortgage and instead invest the capital elsewhere to generate returns.
Mortgage amortization: it’s decision time after a few years
Whether or not repayments over and above the mandatory amortization amount are worthwhile is a very individual matter. Let’s go back to our case study of the Muster family: realizing the dream of owning a home has paid off. The family’s “business plan” has also come to fruition ten years after the purchase. Markus has a good income. Claudia has gone back to work as well, and recently received 60,000 francs from an inheritance.
When the first tranche of a mortgage expires after a few years, homeowners like the Muster family are free to decide: do they want to use the money they have available to pay off their mortgage? Or would it be wiser to invest the money elsewhere?
Mortgage amortization: advantages and disadvantages
The advantage of not amortizing the mortgage is that the family could use surplus income for their private retirement provision. In the future, the Muster family might be glad to have saved up capital for renovations to their property or unplanned repairs, for instance.
There are several disadvantages: if interest rates are high or tending to rise, the interest costs for homeowners will increase. Direct amortization would be the wiser choice in this case. Not being able to amortize is sometimes also associated with higher risks (higher proportion of borrowed capital).
Should you amortize your mortgage? Calculate first, then decide
Interest rates have fallen since the Muster family bought their house ten years ago. In the current environment, it would be possible for the couple to take out follow-up financing at very favorable conditions. The annual interest burden would decrease. If interest rates were to change fundamentally, Claudia and Peter Muster would have to reconsider their amortization strategy.
The fact that the couple has freely available funds gives them a high degree of flexibility. Perhaps there are good reasons for investing in stocks, other securities or in private retirement provision over the long term, for example. And don’t forget that homeowners are often well advised to invest in a financial cushion. If major renovations are needed one day, such as a new heating system, these can easily be financed from this reserve. These would all be valid arguments for not paying off more than is required.
But the amortization of a mortgage has also demonstrated its value, literally: anyone who pays off their debts then owns a larger part of the house. And if the value of real estate should ever fall, amortization is also an advantage. Financing a lower proportion of the lending amount with borrowed capital means increased financial security for the owner and borrower later on.
Mandatory mortgage amortization only: decision time for the Muster family
Even the Muster family from our case study decides against voluntary amortization. After all, they are only five years away from their goal of amortizing the mortgage to two-thirds of the property value. With seamless follow-up financing, they can benefit from the current low interest rates and tax benefits. And they can use their savings to improve their own financial retirement planning by using some of it to make longer-term investments, They will pay the rest into their “Renovation and building maintenance” account – to keep their dream house in perfect condition for the years to come.