When a disagio pays off.

What a disagio is and what it is not

With a disagio, two amounts diverge. The nominal amount is the figure in the contract, the one that carries interest and is repaid. The payout amount is what actually reaches your account. The difference is the disagio, usually expressed as a payout rate, that is as a percentage of the nominal amount.

What matters just as much is what a disagio is not. It is neither a discount nor a fee the bank keeps for its effort. It is interest, simply paid at a different point in time. Over the fixed-interest period the bank forgoes part of the ongoing interest and takes that part immediately instead, in the form of a lower payout. This is why older German banking language calls it damnum or discount.

The counterpart would be an agio, a premium. It hardly ever occurs with loans and is more familiar from securities and fund units. For mortgage financing only the deduction is relevant.

Why the lower nominal rate is misleading

An offer with a disagio looks cheaper at first glance because the nominal rate is lower. This is exactly where many comparisons go wrong. The nominal rate does not reflect the disagio. The annual percentage rate does.

German price indication rules require the costs relevant to the borrower to be included in the annual percentage rate, and a disagio is one of them. If the same bank prices the same project once with and once without a disagio, the annual percentage rates end up close together. The large difference in the nominal rate has largely disappeared.

From this follows the first practical rule: never compare offers with a disagio using the nominal rate. Only the annual percentage rate makes them comparable. Even that is not enough if the fixed-interest periods differ, because a disagio always works on precisely that period. How to choose the right fixed-interest period is covered in our guide on fixed-interest periods.

The worked example, in percentages

Because a disagio is defined as a payout rate, percentages are the clearest way to show it. Take an annuity loan with a ten-year fixed-interest period and compare two variants of the same project.

• Variant without a disagio. Payout rate 100 percent. You receive exactly the amount stated in the contract and pay the agreed nominal rate.
• Variant with a disagio. Payout rate 96 percent, so a disagio of 4 percent. The nominal rate is noticeably lower, often in the region of half a percentage point in this constellation.

The decisive step is often overlooked. If you need a certain amount for the purchase but only 96 percent is paid out, the nominal amount has to rise accordingly. To receive 96 percent in usable funds you need a nominal amount of roughly 104 percent of the capital you actually require. You therefore pay interest on, and repay, more than you use.

The result: the monthly instalment falls because the nominal rate falls. The remaining debt at the end of the fixed-interest period is higher, because it relates to the larger nominal amount. Across the whole period the two effects largely cancel out. That is precisely what the annual percentage rate expresses.

For the financing structure this also means that a disagio increases the loan requirement and therefore the loan-to-value ratio. How much equity you contribute therefore has a double effect.

Owner-occupiers and landlords calculate differently

Up to this point the disagio has been economically close to neutral. The difference only arises from the question of how the property is used. And that difference is the actual reason the instrument still exists.

Anyone who lives in the property cannot claim financing costs for tax purposes. For owner-occupiers a disagio therefore remains what the calculation above showed: a reallocation between payout, instalment and remaining debt. It can make sense if a lower monthly instalment is needed. It is not a cost advantage.

Anyone who rents the property out is in a different position. Financing costs are then income-related expenses from letting. And because a disagio is interest brought forward, the question arises in which year it can be deducted. German law gives an unusually clear answer to that, which the next section sets out.

In practice this means the same contract variant can be assessed completely differently for two clients. At ME Finance we therefore always look at the intended use first, before discussing variants of terms. Our mortgage financing page shows which building blocks also play a role.

When the tax office plays along

Prepayments for a right of use lasting more than five years generally have to be spread evenly across that period for tax purposes. For the disagio, section 11 of the German Income Tax Act makes an explicit exception: the spreading rule does not apply to a damnum or disagio in so far as it is market-standard. For let properties, a market-standard disagio can therefore be recognised in full in the year it is paid.

That shifts the question onto a single word: market-standard. The tax authorities apply a simplification rule that refers to a disagio of five percent where the fixed-interest period is at least five years. Under that administrative practice, anything above is spread across the fixed-interest period.

This threshold is not a hard limit, however. In its judgment of 8 March 2016 (case reference IX R 38/14) the Federal Fiscal Court held that a disagio is only excluded from immediate deduction if it falls outside what is customary on the credit market. Where it is agreed with a commercial bank on arm's length terms, that indicates market conformity. The five percent rule is a simplification, not a statute.

Whether and to what extent this applies in your case is a tax question. It belongs in a discussion with your tax adviser, ideally before the loan agreement is signed. After that, the structure can no longer be changed.

Where the calculation can fail

A disagio ties the benefit to the fixed-interest period. Anyone who exits earlier has prepaid without consuming. Three constellations stand out in practice.

• Sale within the fixed-interest period. Selling before the period ends means the interest brought forward has only partly been used. Whether a proportionate refund follows depends on the contract and is by no means automatic.
• Change of use. If a let flat becomes an owner-occupied one, the basis for deducting income-related expenses falls away for the future. The tax part of the calculation then no longer holds.
• Fixed-interest period too short. The shorter the period, the less time the lower nominal rate has to earn the disagio back. With short periods the arrangement is rarely sensible.

There is also a plain practical point: not every bank offers disagio variants, and whether they are offered at all in a given interest-rate environment differs from institution to institution. It is a tool for particular situations, not a standard building block.

If you would like to know whether a disagio should play any role in your project, we will look at the intended use, the planned holding period and the fixed-interest period together. A non-binding enquiry is enough.