People with Variable Interest Rate Loans in Trouble as Old Financial Thinking No Longer Applies

Mainstream for Home Loans to Shift to Fixed Interest Rates? In the US, 90% Have Fixed Rates.

With the Bank of Japan’s first rate hike since 2007, the “world of interest rates” has made a comeback. Some predict that the policy interest rate could reach 1% by 2026.

Japan, accustomed to prolonged ultra-low interest rates, faces uncertainty about the future of its economy. What impact will this have on financial products and household finances? We asked financial planner Kenji Matsuoka.

In a press conference following the July 31 monetary policy meeting, Bank of Japan Governor Kazuo Ueda stated that if economic and price conditions progress as forecasted, “We will continue to raise the policy interest rate.”

Subsequently, the financial markets experienced rapid changes due to the Bank of Japan’s rate hike and hints of a rate cut by the US Federal Reserve. The Bank of Japan rushed to contain the situation, with Vice Governor Shinichi Uchida clearly stating in a speech in Hakodate, Hokkaido on the 7th of this month that “In the current unstable financial capital market, we will not raise rates.”

Will there be additional rate hikes or not?

“Most participants in the short-term financial market expect the Bank of Japan to raise the policy interest rate by 0.25% to 0.5% by March 2025. They also anticipate another rate hike in September or October 2025, bringing it to 0.75%. Moreover, there seem to be quite a few economists predicting that it could rise to 1% by the end of March 2026.

When the policy interest rate rises, it affects the interest rates on financial products handled by financial institutions. First, those with loans are likely to face increased burdens. Among these, the increase in home loan interest rates seems to pose a significant headwind for household finances.”

Home loans are broadly categorized into two types: ‘variable interest rate’ loans, where the interest rate is reviewed every six months, and ‘fixed interest rate’ loans, where the rate remains constant.

Variable interest rates are largely tied to the “short-term prime rate” (hereinafter “short-prime”) based on the Bank of Japan’s policy interest rate. Many financial institutions add a fixed margin of about 1% to the short-prime rate to determine the “reference interest rate” for home loans. When the short-prime rate rises, the reference interest rate for variable interest loans also increases, which is reflected in the actual borrowing rate, known as the “applied interest rate.”

On the other hand, fixed interest rates are determined based on the “long-term interest rates,” which are indexed to the yield on 10-year government bonds. Thus, when long-term interest rates rise, fixed interest rates will rise accordingly.

“Following the Bank of Japan’s rate hike, some online banks have increased their variable interest rates. au Jibun Bank announced a 0.25% increase in the reference interest rate for variable rates. Since major banks and regional banks have already announced hikes in the short-prime rate, it is reasonable to expect variable rates to increase as well.”

Currently, about 80% of home loan users are said to choose variable interest rates. However, Mizuho Research & Technologies released the following estimate as of April.

In a world with interest rates (assuming the Bank of Japan raises rates by 0.25% every three months from 2024 to 2026), “households will shift from variable interest rate loans to fixed interest rate loans to avoid future risk of increased interest payments,” and the proportion of new borrowings choosing variable rate loans is expected to decrease in line with rising interest rates. It is projected that by the fiscal year 2026, fixed interest rate loans will account for 80%.

“Currently, the lowest interest rate for the fixed-rate ‘Flat 20’ home loan is 1.46%. If you can endure an interest rate burden of 1.46% with a repayment period of another 20 years and with home loan tax deductions already ended, refinancing from a variable rate to a fixed rate is certainly a viable option.

If you are considering refinancing, it’s better to do it sooner rather than later. Refinancing has advantages such as stabilizing monthly repayment amounts, eliminating concerns about rising interest rates, and making it easier to plan for future expenses like education and retirement.”

 

The Benefits Are for Financial Institutions

Of course, there is also the disadvantage that if variable interest rates rise, you will end up losing.

“What’s concerning is how the economy will fare if the Bank of Japan aggressively continues raising rates. There are quite a few market participants who think Japan will fall into a recession.

If the expectation of a recession strengthens, short-term interest rates will remain high while long-term interest rates start to fall. This will create an inverted yield curve where long-term rates are lower than short-term rates. Looking at past examples, this is quite a possible scenario.

After an inverted yield curve occurs, a reduction in the policy interest rate is generally anticipated, and variable interest rates will also fall accordingly. Therefore, refinancing to a fixed rate may not be a good strategy.

In fact, in the US, an inverted yield curve has persisted for about two years. It briefly resolved at the beginning of August but has returned to an inverted state.”

So, one might wonder if people in the US with variable interest rate home loans are facing a greater burden in interest payments compared to those who chose fixed rates.

“In the US, about 90% have fixed rates. It is only Japan where there are many users of variable interest rates.

By the way, variable interest rate loans are products where financial institutions do not take on the risk. In other words, the borrower takes the risk. With fixed interest rates, financial institutions also take on the risk. For example, ‘Flat 35’ is a loan where the repayment amount remains constant for up to 35 years, and the financial institution absorbs all the risk regardless of how much interest rates rise in the future.

Despite this, the proportion of variable interest rate loans has increased so much in Japan because ultra-low interest rates persisted for a long time, and the view that interest rates will not rise in the future became mainstream without people noticing.

However, interest rates can both rise and fall, and variable interest rates carry significant risk. I think it is only now that this risk is beginning to become apparent.”

The “world of interest rates” is likely to affect the choice between variable and fixed interest rate home loans.

 

“Reduce Risk Rather than Increase Assets!” What’s Needed in an Era of Interest Rates is a “Defensive Stance”.

What about the positive effects of rising interest rates on household finances? Since the Bank of Japan’s rate hike, interest rates on savings and deposits have started to increase.

“If the policy interest rate rises to 1% in the future, there is a significant possibility of a strong yen, which would negatively impact the Japanese economy. In a situation where the future of the economy is uncertain, it might be wiser to focus on protecting assets rather than increasing them.

As a defensive measure to protect assets, I believe individual government bonds are the best option.”

Individual government bonds, which promise “no loss of principal,” include fixed interest types such as “fixed 5 years” and “fixed 3 years,” as well as a variable interest type called “variable 10 years.” Matsuoka recommends the 10-year maturity “variable 10 years.”

“The variable 10 years offers a guaranteed minimum interest rate of 0.05% and the applicable interest rate changes every six months, so you can expect an increase in interest received. For those with children who will be going to college in a few years, this might be a good option to consider.”

Considering the future, such as 10 years or beyond, what about investment plans like NISA?

“If prioritizing asset protection, the variable 10 years seems to be the most reliable choice.

For those over 50 who want to increase their retirement funds even a little, I recommend iDeCo. However, it should be regular deposits, not investment trusts within iDeCo.

In addition to the tax-free growth of investments in iDeCo, there is the advantage that contributions to regular deposits are fully deductible from income. Although there is a fixed fee throughout the year, for example, if your annual income is 7 million yen, a monthly contribution of 20,000 yen can reduce your taxes by about 70,000 yen annually.

Even after deducting account management fees (the lowest is 171 yen per month), there are significant benefits. I think regular deposits through iDeCo are a viable defensive strategy.”

According to estimates from Mizuho Research & Technologies, for households in their 30s and 40s with liabilities such as mortgages, the negative impact of increased loan repayment burdens due to rising interest rates seems to outweigh the positive effects of increased financial assets. As Matsuoka points out, in a “world with interest rates,” it may be wise to adopt a defensive stance.

“People with home loans have effectively taken on the maximum risk at the time they took out the loan. From that moment on, it is safe to say they entered a defensive phase of their financial life. Instead of focusing on increasing wealth through investments, it is wiser to think about how to avoid losing money. I believe this approach is more prudent.”

 

Kenji Matsuoka is a money writer and financial planner. After working as a market analyst at a securities company, he became independent in 1996. He writes articles on finance and asset management primarily for business and economic magazines. His books include The Textbook for the First Year of Robo-Advisor Investment and A Comprehensive Guide to Cashless Payments: The Book That Guarantees You Will Benefit.