Either of the amortization methods will have a financial impact on you, choose wisely.

When it comes to property buying, besides the load, the other thing you need to think carefully about is amortization. Because direct or indirect amortization will incur some opportunities cost for you if you don’t choose wisely according to your own situation. And it will probably will a long term path which you have to stick to it. This article will explain what they are, and compare the pros and cons. Then you will be better informed and make the right decision.

What is Amortisation

Amortisation is an accounting process to gradually reduce the book value of the assets or loans. In property buying, an amortisation schedule is a plan to reduce your loans. For example, if you are buying $400,000 value of a property, you put 20% or $80,000 as a downpayment, then you make a loan of $320,000 from a bank. How you want to pay back the $320,000 is the amortisation plan. And interest is on top of this payment.

Simply, you borrow money from a bank with a term of 15,20 or whatever number of years. In order to pay back, you need to have 2 types of payment:

1. The interest. Bank lends you money for interest, that’s how they make money. Usually the longer the borrowing period, the higher the interest rate is. Because long term borrowing increases the risks than short-term, that risk is reflected in the interest rate.

2. Amortisation. Over the years, you will slowly ‘buy-back’ the property. Because in the beginning, you ‘own’ 20%, and the bank ‘own’ 80%. Through amortisation, you are increasing your ownership. However, each country has its own requirement. In Switzerland, one does not need to ‘buy-back’ 100% of the property, if the loan is less than 2/3 of the property value, they can choose only to pay interests for the outstanding loan.

Direct Amortisation

As the name suggests, direct amortisation means you pay back the outstanding loan directly to the bank at a regular interval. Let’s use the same example here, and assuming the numbers are:

Property value: $400,000

Downpayment: $80,000

Loan: $320,000

Interest rate: 1%

Mortgage term: 15 years (180 months), 180 payments.

If you do direct amortisation, your outstanding loan will decrease over the years. If you are making monthly payments for a fixed amount including both interest and amortisation. Then the mix of the 2 might be 86% amortisation, 14% interest. over the years, the % from amortisation will increase and % from interest will decrease close to 0.

The chart shows you the first 6 vs last 6 payments. You can see that interest payment is decreasing each month because you have less and less outstanding loan amount.

In Switzerland, one does not have to pay back all the outstanding loans. But they have reduced the loan amount to less than 2/3 (66.7%)of the total property value. If a person pays 20% downpayment, and borrow the 80% from a bank. He or she needs to pay the 13.3% (80% minus 66.7%) of the property value through amortization within 15 years or till the retirement age whichever comes earlier. The rest of the 66.7% property value is on loan and does not need to be paid back. But then the interest payment will be constant forever.

Let’s look at the pros and cons of direct amortization.

pros:

• lower interest payment over time

• lower debt

cons

• as interest payment is tax-deductible in Switzerland, lowered interest means potential higher tax bracket. Thus more tax.

• opportunity cost from investment. If you choose direct amortization, the money is paid to the bank. If you choose indirect amortization, you can invest them and gain a return which is higher than the interest rate (if possible), and pledge this to the bank. So you can make a gain from the difference between investment return and interest. By making direct amortization, you could make an opportunity loss.

• wealth tax. In Switzerland or other countries, you need to pay a wealth tax if your asset is over a certain amount. By making direct amortization, you are increasing your asset and this could make you eligible or pay more wealth tax.

Indirect Amortisation

Instead of paying the bank with cash directly, you can pledge the payment through an insurance product or investment. It is like you promise the bank that you will pay the amortisation in the future, but you don’t pay it now, and you use your investment or an insurance product as a guarantee or collateral. Most likely you have to make a regular deposit into the investment. The graph below shows the difference.

This graph does not show the interest amount. It only shows how outstanding loan is reduced. At the end of the 15 years, they will have the same result. If you choose not to pay back all outstanding loans, such as the case in Switzerland. In 15 years, you will own the same % of the total value of the property no matter which method you use to amortize. The only difference is interest payment. Remember the table above shows you how interest is decreasing over the years? In indirect amortization, the interest remains the same until year 15. Because you did not make actual payback of the loan so your loan amount remains the same, thus interest remains the same. if you pay more interest than using direct amortization, why people choose indirect amortization then? Let’s look at the pros and cons.

pros:

• 3 tax benefits.

1. Instead of using money to pay back, you can put it into a pillar 3a insurance or pillar 3a investment every month. Pillar 3a is a voluntary pension fund, the contribution is tax-deductible. For more info refer to articles on the Swiss pension fund and pillar 3a. It is similar to the Roth IRA in the US. But when you take out money from pillar3a, it is subject to a much lower tax rate. You can only withdraw the money for certain purposes and every 5 years. This pillar3a investment or insurance is used for indirect amortization.

2. wealth tax. since your outstanding loan remains at the high amount, your total asset will be less compared to direct amortization, thus potentially lower wealth tax.

3. interest payments are tax-deductible. By having the same amount of interest, you can subtract that from taxable income. Compared to direct amortization, which your subtraction is decreasing, you might benefit from a lower tax due to same amount of interest payment.

• gains through investment. If your pillar 3a investment brings you estimated above 1%(assumed interest rate in our example), let’s say 3%. Then your return is 2%. 1% to cover the interest payment. After 15 years, your average return from your pillar3a investment would be 2%. But how do you know if your investment return will be higher than the interest rate? well, you don’t, but you can make a calculated estimation. The current interest rate offered by swiss banks is about 1%. (I know it is extremely low compared to many other countries). And last 10 years Vanguard VT total world ETF obtained an 8,73% annual return. Swiss Market Index obtained an 8.02% annual return in the past 10 years. (https://www.ishares.com/ch/individual/en/products/261154/ishares-smi-ch-fund). What I mean is that either you buy a market index or even a total world diversified ETF, the return is higher than 1%. Or if your interest rate is higher than 1%, as long as you can find an investment in which you are confident that the return will be higher than the interest rate, then it has an advantage. Otherwise, this point is not a pro.

• insurance coverage. If you choose to buy insurance which has an investment element. Then you can use it for indirect amortization and get insurance coverage for you and your families. Similar to the last point in the investment aspect. Depends on your expected return, it might be good to put money there.

cons

• The consistent interest payment amount.

• Investment subjects to market fluctuations

How to Choose

From the analysis, you can see that much of the deciding factor lies in your personal situation. How much is your taxable income, how much asset do you own and how much wealth tax do you pay, how high is your interest rate, what is your age if you need to amortize 13.3% value within 15 years. Do you have a chosen investment for pillar 3a and could generate good returns.

What you need to do is calculate the tax, the interest payment, the returns. Compare 2 scenarios and you would know which one is better for you.

Let me know which method do you choose and why.