Acquiring real estate in Switzerland is often synonymous with using a mortgage, an essential loan unless you have a substantial amount of equity. Credit institutions generally require you to contribute at least 20% of the value of the property in equity that can come from various sources such as your personal savings, your 2nd or 3rd pillar, a donation, or the value of real estate that you already own. It is important to note that FINMA requires 10% of these equity funds to be “personal”, i.e. they come from sources such as traditional savings or the 3rd pillar.
Once this equity is built up, the bank can finance up to 80% of the purchase, divided between a first mortgage covering two-thirds of the financing and a second mortgage for the remaining third.
How does mortgage lending work in Switzerland?
In Switzerland, a mortgage is a commonly used solution to finance the purchase of real estate. The process starts with the accumulation of equity by the borrower, usually at least 20% of the value of the property. Mortgage financing covers the rest, divided into 1st and 2nd tier mortgages, each meeting specific criteria and conditions.
What is a 1st and 2nd mortgage?
1st Rank Mortgage:
- ‍Definition: A first mortgage is the main portion of your mortgage. It covers up to 66% (two thirds) of the market value of your property.‍
- Interest rate: Interest rates for first-tier mortgages are generally lower, reflecting the reduced risk for the lender.‍
- Duration: There is no fixed term and limit to repay the 1st mortgage, thus offering a certain flexibility to the borrower. It is thus possible to never repay this debt and to only pay the interest on it.
2nd Rank Mortgage:
- ‍Definition: The 2nd mortgage complements the financing beyond the 1st rank, generally covering the remaining 10 to 15% until reaching 80% of the total financing of the property.‍
- Interest rate: Because of the higher risk associated with this financing bracket, interest rates are generally higher by around 0.5 to 1% compared to the 1st rank.‍
- Depreciation obligation: Unlike a first-rank mortgage, a second-rank mortgage must be systematically amortized. This means that the amount borrowed must be repaid within a specified period of time, usually within 15 years or at the latest before the borrower's retirement age.
The concept of debt ratio
The debt ratio is a key criterion in evaluating the borrower's ability to support a mortgage loan. It represents the ratio between the total cost of the mortgage (including interest, ancillary costs, and amortization) and the borrower's gross income. In Switzerland, this rate should generally not exceed 33%, ensuring that the borrower has enough income to meet his financial commitments while covering his other living expenses.
Direct and indirect amortization: what are the differences?
As mentioned earlier, in Switzerland, when taking out a mortgage, it is imperative to amortize the 2nd mortgage. In this context, amortization means the gradual repayment of the principal sum borrowed in addition to the related interest. This process allows the total amount owed to be gradually reduced, until the debt is fully repaid.
Direct amortization of a 2nd mortgage
During direct amortization, Each payment you make gradually reduces the balance of your 2nd mortgage, thus reducing both the principal and the interest. However, this reduction has a double fiscal impact: on the one hand, it increases your tax burden by reducing the interest deductions available since the capital is gradually repaid, and on the other hand, it increases your taxable wealth by reducing your debt.
Advantages:
- Continued reduction in your mortgage debt.
- Reduction in interest expenses over time.
- Direct contribution to the accumulation of your real estate capital.
Disadvantages:
- Potential increase in your tax burden due to reduced interest tax deductions.
- Progressive increase in your taxable wealth, thus increasing your wealth taxes
- Need for additional budgetary allocations for your private pension.
Indirect amortization of a first mortgage
When you opt for indirect amortization, each year you allocate a specified amount to a pension product, such as a 3rd pillar 3a or life insurance, which acts as collateral for the lending financial institution. Unlike direct amortization, the capital on your 2nd mortgage remains constant throughout the loan period, which means that the amount of debt is not reduced over time. This method offers significant tax benefits: you can deduct contributions to the 3rd pillar 3a as well as mortgage interest from your taxes, which remain the same. Later, you can use the capital accumulated in your 3rd pillar 3a to pay off your mortgage in full, either at maturity or when you retire.
Advantages:
- You have the option of deducting the interest on the 2nd mortgage from your taxable income until it is repaid.
- All mortgage debt is deductible from your taxable assets until the 2nd mortgage is paid off.
- Contributions to pillar 3a are also deductible from your taxable income.
- By choosing a 3rd pillar with high returns, the accumulated capital grows, thus increasing the funds available to more easily repay your mortgage at maturity.
- When withdrawing, the funds accumulated as part of the pension plan are subject to a taxation at a reduced rate.
- In the event of death or disability, the amortization policy offers financial protection (applicable only for insurances, not for 3a bank accounts).
Disadvantages:
- The principal amount of your mortgage remains the same until the final repayment is made.
- The interest expenses you pay each year don't decrease over time.
What should you choose between direct and indirect amortization?
The decision to opt for direct or indirect amortization when repaying a mortgage is not to be taken lightly, but there is no single solution that applies to all. This choice actually depends on several factors that vary from person to person, making the decision highly individual.
To navigate this complex decision, it is advisable to perform an accurate simulation, comparing the long-term financial results of each option. A financial advisor can be a great help in this process. It can take into account all aspects of your financial situation, including your long-term goals and tax situation, to guide you towards the amortization strategy that's best for you.
Depreciate a 2nd mortgage with a 3rd pillar
Use a 3rd pillar to amortize a 2nd mortgage is a smart financial strategy in Switzerland, allowing borrowers to take advantage of tax advantages while preparing the ground for effective repayment of their loan.
In this approach, instead of repaying the 2nd mortgage directly, you make regular payments into a 3rd pillar pension account. This capital, which grows thanks to the interest and potential returns on the account, is intended to pay off your 2nd mortgage at a later date, generally at the end of the loan or at retirement.
Here are the key steps in this process:
- Establishing the Plan: You define an indirect amortization plan by determining the amount to be paid annually into your 3rd pillar, in line with the total amount to be repaid for the 2nd mortgage.
- Payouts: You make regular payments into your 3rd pillar insurance account or policy. These payments are generally deductible from your taxable income, offering tax savings each year.
- Accumulation and performance: Funds in the 3rd pillar accumulate over time, taking advantage of potential returns according to the type of product selected. This growing capital contributes to the constitution of a sufficient sum to repay the 2nd mortgage in the long term.
- Refund: At the agreed time, the capital accumulated in the 3rd pillar is used to fully repay the 2nd mortgage. If the returns are higher than expected, they may even provide a surplus that will be available to you.
By choosing this method, you not only benefit from the tax advantages associated with the 3rd pillar, but you also create a repayment plan that can be adapted to your financial needs and long-term goals, while taking advantage of possible growth in invested capital.
What is the best 3rd pillar for indirect amortization?
Choosing the ideal 3rd pillar for the indirect amortization of your mortgage is not a decision that should be taken lightly, as there is no one-size-fits-all solution. The best option varies based on a multitude of factors that are unique to each individual.
- Tax situation: Your current and future tax situation may influence the choice of the 3rd pillar, as the tax benefits associated with these solutions vary according to individual circumstances.
- Lending institution: The conditions set by your lending institution may influence the choice of your 3rd pillar. Some lenders have specific preferences or requirements regarding the 3rd pillar used for indirect amortization.
- Personal preferences: Your expectations in terms of risk, return, and coverage are critical. Some will prefer a 3rd pillar offering higher security with potentially lower returns, while others may opt for riskier options with higher chances of returns.
Given the complexity and importance of this decision, it is crucial to conduct a detailed comparison of the options available on the market, taking into account your specific needs and long-term goals. The assistance of a financial advisor can be invaluable in this process. A professional can provide you with personalized advice, help you navigate through the various options and assist you in selecting the 3rd pillar that will optimize your indirect amortization strategy while aligning with your wishes and your overall financial goals.
