Indirect Amortization

1. What is Indirect Amortization?

In indirect amortization, instead of directly repaying the mortgage principal to the bank, you make contributions to a pillar 3a account (a tax-advantaged private retirement savings account in Switzerland). The funds in the pillar 3a account are pledged to the bank as collateral for the mortgage. At the end of the agreed period (e.g., upon retirement or sale of the property), the accumulated savings in the pillar 3a account are used to repay the mortgage.

This approach has two key benefits:

1. Tax Savings: Contributions to a pillar 3a account are tax-deductible, reducing your taxable income.

2. Interest Deduction: Since the mortgage principal is not reduced, the interest payments remain higher, allowing you to deduct more interest from your taxable income.

2. Direct vs. Indirect Amortization

Aspect

Direct Amortization vs Indirect Amortization

How it works

You repay the mortgage principal directly to the bank. vs You contribute to a pillar 3a account instead of repaying the principal.

Mortgage Principal

Decreases over time. vs Remains constant until the pillar 3a account is used to repay it.

Interest Payments

Decrease over time as the principal decreases. vs Remain constant because the principal is not reduced.

Tax Benefits

Lower interest deduction over time. vs Higher interest deduction and tax-deductible pillar 3a contributions.

Flexibility

Less flexible (principal is repaid directly). vs More flexible (pillar 3a funds can grow and be used later).

3. Example: Indirect Amortization with Tax Benefits

Let’s revisit the CHF 1,000,000 mortgage example and assume the following:

• Loan Amount: CHF 1,000,000

• Property Value: CHF 1,250,000

• First Mortgage: CHF 812,500

• Second Mortgage: CHF 187,500 (subject to amortization)

• Annual Pillar 3a Contribution: CHF 12,500 (instead of direct amortization)

• Taxable Income: CHF 150,000 (before deductions)

• Marginal Tax Rate: 25% (combined federal, cantonal, and municipal taxes)

Step 1: Tax Savings from Pillar 3a Contributions

Contributions to a pillar 3a account are tax-deductible. By contributing CHF 12,500 annually, you reduce your taxable income by the same amount. The tax savings are:

[ \text{Tax Savings} = \text{Pillar 3a Contribution} \times \text{Marginal Tax Rate} ]

[ \text{Tax Savings} = 12,500 \times 25% = CHF 3,125 ]

So, by using indirect amortization, you save CHF 3,125 in taxes annually.

Step 2: Interest Deduction

With indirect amortization, the mortgage principal remains constant, so the interest payments do not decrease over time. This allows you to deduct the full interest amount from your taxable income.

For a SARON-based mortgage:

• Loan Amount: CHF 1,000,000

• Total Interest Rate: 1.05% (SARON + Bank Margin)

• Annual Interest Payment: CHF 10,500

The interest payment of CHF 10,500 is tax-deductible. The tax savings from the interest deduction are:

[ \text{Tax Savings from Interest} = \text{Interest Payment} \times \text{Marginal Tax Rate} ]

[ \text{Tax Savings from Interest} = 10,500 \times 25% = CHF 2,625 ]

Step 3: Total Tax Savings

The total tax savings from indirect amortization are the sum of the tax savings from the pillar 3a contribution and the interest deduction:

[ \text{Total Tax Savings} = \text{Tax Savings from Pillar 3a Contribution} + \text{Tax Savings from Interest} ]

[ \text{Total Tax Savings} = 3,125 + 2,625 = CHF 5,750 ]

4. Comparison of Costs: Direct vs. Indirect Amortization

Let’s compare the total annual costs for direct and indirect amortization, including tax savings.

Direct Amortization

• Annual Amortization: CHF 12,500

• Annual Interest Payment: CHF 10,500 (decreases over time as the principal is repaid)

• Tax Savings from Interest: CHF 2,625 (decreases over time)

• Net Annual Cost: (12,500 + 10,500) - 2,625 = CHF 20,375

Indirect Amortization

• Annual Pillar 3a Contribution: CHF 12,500

• Annual Interest Payment: CHF 10,500 (remains constant)

• Tax Savings: CHF 5,750 (from pillar 3a + interest deduction)

• Net Annual Cost: (12,500 + 10,500) - 5,750 = CHF 17,250

5. Advantages of Indirect Amortization

1. Tax Efficiency: Indirect amortization allows you to maximize tax deductions by keeping the mortgage principal constant and contributing to a tax-deductible pillar 3a account.

2. Retirement Savings: The pillar 3a account grows over time, providing a financial cushion for retirement.

3. Flexibility: You retain control over the pillar 3a funds, which can be used for other purposes (e.g., early withdrawal for home purchase or retirement).

6. Key Considerations

• Investment Returns: The funds in the pillar 3a account may grow over time, depending on the investment strategy (e.g., cash, bonds, or equity funds). This can further enhance the benefits of indirect amortization.

• Bank Requirements: Not all banks allow indirect amortization, so it’s important to check with your lender.

• Tax Implications at Withdrawal: When you withdraw funds from the pillar 3a account (e.g., to repay the mortgage), the withdrawal is subject to a one-time tax, which is typically lower than regular income tax rates.

Conclusion

Indirect amortization can be a highly tax-efficient way to manage your mortgage in Switzerland. By contributing to a pillar 3a account instead of directly repaying the mortgage, you can:

• Reduce your taxable income,

• Maintain higher interest deductions, and

• Build retirement savings.

For the CHF 1,000,000 mortgage example, indirect amortization results in annual tax savings of CHF 5,750 and a lower net annual cost (CHF 17,250) compared to direct amortization (CHF 20,375). However, the choice between direct and indirect amortization depends on your financial goals, risk tolerance, and tax situation. It’s advisable to consult with a financial advisor to determine the best strategy for your specific circumstances.