Maximize special repayments on a mortgage loan or buy ETFs instead?

Special repayments preferred by the majority

Reducing the large debt of a mortgage loan is considered mentally relieving by many homeowners, who therefore choose special repayment over ETF savings, as reflected in online discussions on this topic.

Rationally speaking, depending on interest rates, it can make sense to buy ETFs instead of putting the same money into the special repayment of the mortgage loan.

For instance, if loan interest rates are around 4 percent or less, investing in ETFs would be more profitable in the long run after taxes, generating returns of 5.5 to 7.2%, albeit with the risk that prices might stagnate or even decline for months or years.

ETFs are relatively safe, special repayment is very safe

ETFs have historically proven to be profitable and stable. Market downturns do occur, however, and can last for several years.

On the other hand, paying off the loan through special repayments is a very safe option. With the special repayment, you are guaranteed to have earned the current loan interest of up to 4%.

ETF gains are taxable, special repayments are not

Gains from the sale of ETFs are subject to capital gains tax, solidarity surcharge (which still applies to capital gains tax), and, if applicable, church tax.

If the equity portion of the ETF is over 50%, 30% of the ETF gains are tax-free (Investment Tax Reform Act 2018).

Assuming the ETF is an equity ETF, we include the 30% tax-free portion in our calculations. This results in the following overall tax burden on ETF gains:

Loan without special repayment if ETFs are planned anyway

A special repayment option of up to 5% annually is relatively common and is often granted by banks without affecting the interest rate.

Some banks do not offer special repayment. Here, you would have to pay for the special repayment option with a higher interest rate.

If a special repayment option is part of the loan, the bank often does not reduce the interest rate if you opt out of this option.

If you want to increase the special repayment option to, for example, 10% annually, the bank will charge a higher interest rate.

Even with an increased interest rate due to a 10% special repayment option, there is still a gap (as of August 2024) between loan interest (still below 4%) and typical ETF returns after taxes (more than 5.5%).

If ETF savings are planned instead of special repayment, it makes sense to aim for a loan without special repayment and a correspondingly reduced interest rate.

Risk of ETF prices being low when needed

In the long term, the stock market goes up, but longer bear markets do occur from time to time.

The last market downturns were the dotcom bubble burst in 2000 and the financial crisis in 2007/2008.

These bear phases lasted 30 (2000) and 17 months (2007/2008), respectively.

Even longer downturns are conceivable: After the stock market crash of 1929, it took until 1954, or 25 years, for prices to return to their previous highs.

A 25-year bear phase like the one nearly 100 years ago is unlikely to recur.

However, to be on the safe side, you should still plan for up to two or three years of a bear market.

ETFs instead of special repayment: Worthwhile but somewhat risky

You don’t have to sell the ETF on a specific date. Since a mortgage usually runs for many years, it should be possible to find a favorable, pre-planned sale date.

One possible approach could be to invest available money in ETFs initially and, a few years before the mortgage term ends, shift more and more into fixed or overnight deposits or use the available special repayment options directly.

Start with ETFs, move to special repayments & fixed/overnight deposits toward the end

You could invest in ETFs for the first 7 years and forgo special repayments. Three years before the legal special termination right, which applies after 10 years, you start maximizing special repayments if allowed in the loan agreement.

Once the special repayments are exhausted, any remaining ETF funds can be transferred into overnight or fixed deposits to avoid the risk of a sharp drop in ETF prices shortly before the statutory termination date (after 10 years of the loan term).

ETFs instead of special repayment: Even more interesting with low loan interest rates

Since mortgage loan interest rates are currently comparatively high compared to the low-interest phase we had for a long time, the decision for ETFs instead of special repayment is somewhat challenging.

If interest rates were close to 1 percent again, this would favor ETFs even more.

Currently, the decision in favor of ETFs is rather for financially and mentally strong investors whose financing is not at risk even if they unexpectedly suffer losses with ETFs instead of special repayment.

The difference between special repayment and a nearly guaranteed “gain” of almost 4% and a likely but not guaranteed ETF gain after taxes of around 5.5 to 7% is about 1.5 to a maximum of 3.5 percentage points.

Example calculation: Special repayment versus ETF savings

We consider the first 10 years of a mortgage. The interest rate is fixed for the term; after that, everything is renegotiated with the special termination right, meaning you can refinance or repay in full if you have the funds.

First, let’s look at how much ETF savings accumulate in 10 years at the interest rates indicated above. We assume that, similar to special repayment, a fixed amount is invested in ETFs once a year.

We also assume that the ETF purchase or special repayment is made at the beginning of each year to allow for an accurate comparison.

The first ETF purchase generates interest for 10 years, the second ETF purchase for 9 years, and so on.

Now we compare the remaining debt after 10 years without and with special repayment, as well as alternatively with ETF savings and an ETF return of 8.64%, 7.42%, 6.17%, and 4.94%. The whole thing is then done with an initial annual repayment rate of 1 or 2 percent:

The loan amount is 386,280 EUR from the example above.

As you can see, even an ETF return of 6.17% beats the special repayment by around 7,000 EUR after 10 years (remaining debt of 206,000 vs. 213,000 or 159,000 vs. 166,000 EUR).

If the ETF savings achieve an average of 7.41% before taxes, ETFs come out ahead by 15,000 EUR.

And if the ETF performs at a still realistic 8.64% per year, the ETF advantage after 10 years is a substantial 23,000 EUR.

Only when the ETF return drops to 5% does the ETF savings plan perform roughly on par with annual special repayments of the same amount.

Disadvantage of ETFs when receiving social benefits

A loan for an owner-occupied property can continue even while receiving citizen’s income. The agency covers the loan interest, as the alternative would be to cover rent costs.

One disadvantage of ETFs compared to special repayment is that ETF assets above the exemption amount would be counted when receiving citizen’s income.

In contrast, the mere option for special repayment is not an asset that could be counted. Since you make annual special repayments instead of accumulating wealth over several years, there would likely be less accumulated wealth at the beginning of the need for assistance.