"We had a very constructive day today and we reached a lot of agreements", said SPD General Secretary Lars Klingbeil, pointing to deals on rents and real estate, digitalisation and culture.
"We did good groundwork yesterday but there are still important issues that need to be resolved", Merkel told reporters before heading into the talks.
As he arrived for talks, SPD leader Martin Schulz said the sides had edged closer on many issues but were still clashing over the SPD's bid to bar employers from imposing short-term employment contracts without justification.
"So we've decided together that we won't have a night session tonight but rather that we will continue our negotiations and discussions in a detailed and focused way here in Willy Brandt House from 10 o'clock tomorrow", he said, referring to the SPD headquarters.
The effort to stitch together a governing coalition has already lasted longer than any negotiations since before the Second World War, and will not finish with these talks.
SPD negotiator Manuela Schwesig, aware of the need to push through distinctive SPD policies to sell the deal to the party at large, said: "We've promised our members that we'll negotiate until the other side squeals, and we'll do that".
More than four months after an election beating for both parties, "the coalition agreement is gradually coming into shape" between the Christian Democratic Union (CDU) and Social Democratic Party (SPD), Merkel's chief whip Michael Grosse-Broemer said late Saturday.
"I'm going into talks with goodwill today, but I also expect that we'll face hard negotiations in today's session", she added.
The conservatives and SPD had hoped to agree on Sunday to renew the "grand coalition" that has governed Germany since 2013, but disputes over healthcare and labour policy remain.
They reached a deal on migration on Friday, agreeing to stick to the wording of January's coalition blueprint that said the parties did not expect annual migration to exceed 220,000 per year.
Economic and military partners have been watching impatiently as the two prominent German political parties bicker for advantage, both fearing a resurgence of the country's nationalistic far-right.
But the two blocs were still wrangling over its meaning on Saturday, with Joachim Herrmann - a member of Merkel's CSU Bavarian allies who have called for an upper limit - telling the Rheinische Post his party had secured a migrant cap.
Schulz, who had previously ruled out forming another "grand coalition" between Germany's biggest parties, ultimately changed his mind, attracting some criticism from certain parts of his party.
Germany could still face new elections or an unprecedented minority government if SPD members reject a coalition deal. Or it may force her to hold fresh elections.
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