Choosing Between Fixed vs. Floating Interest Rates in Japan: Which is the better option?

This article is a supplemental article to our comprehensive debt financing guide: Complete Guide to Real Estate Loans in Japan. We strongly advise reading through this first if you are currently contemplating your financing options.

Introduction to Understanding Interest Rates in Japan

When considering debt financing for your home or investment loan, the choice between fixed and variable interest rates is crucial, as each option comes with its own set of advantages and risks. While this article does not aim to make a definitive recommendation or predict future rate movements, we will offer insights into the decision-making process through historical context, exploring the pros and cons, and providing financial implications of each option. Through this we hope you can gauge your own risk tolerance and make an educated guess on the outlook of future macro-economic conditions as these are vital aspects in choosing between the two options.

Like in any large financial decision making process, it is critical to understand the history of your investment, not just the current trend. Japan’s interest rate policy has a long history, which we’ve summarized below.

Quick History Lesson on Japan’s Interest Rate Policy

Japan is recognized for having some of the world's historically low interest rates, earning a reputation as a global safe-haven due to its traditionally conservative government policies. Since the burst of the economic and asset price bubble in the early 1990s, the Japanese government and Bank of Japan (BoJ) has adopted a deliberate and prolonged strategy of maintaining low, near-zero interest rates during a period of prolonged economic stagnation, deflation, and financial instability or the “Lost Decade(s)” in order to stimulate economic growth and combat deflationary pressures.

The primary objective behind keeping interest rates low was to encourage borrowing and spending, and stimulate economic activity. By reducing the cost of borrowing, the government aimed to incentivize businesses to invest, consumers to spend, and ultimately reignite economic expansion. Additionally, low-interest rates served as a tool to address deflationary tendencies by encouraging inflation, as higher prices would make borrowing more attractive than hoarding money.

In addition to its role in stimulating economic growth and addressing deflationary pressures, the sustained low-interest-rate environment in Japan has been pivotal in managing the country's formidable public debt, which is currently the highest in the world. This extensive debt is largely funded through the issuance of Japanese Government Bonds (JGB), and the Bank of Japan (BoJ) plays a central role in this process. The BoJ, influenced by the economic policies of “Abenomics” between 2012-2020 and additionally throughout the pandemic and global inflation, purchased a substantial portion of JGBs as part of its monetary policy, effectively providing a consistent source of funding for the government. A sudden surge in interest rates, particularly in the post-Abenomics era, could lead to a considerable rise in the government's interest payments, diverting a significant portion of the budget towards debt servicing and potentially triggering a fiscal crisis.

Amid the backdrop of the COVID-19 pandemic and heightened global economic uncertainty, Japan has encountered domestic challenges exacerbated by its own rising inflation and a swift weakening of the yen, driven in part by the concurrent global interest rate hikes to combat inflation. Responding to these dynamics, Japan has undertaken measures to address the situation, notably by loosening its control on historically low Japanese Government Bond (JGB) rates. While this policy adjustment has not been passive in nature and interest rates are still below the 10-year average, it has caused volatility and uncertainty in short to mid-term. The recent implications in BoJ policy has also reverberated in the real estate sector's fixed-term loan rates, as banks brace for future volatility.

Floating vs. Fixed Interest Rates Overview

When deciding between variable and fixed interest rates, the ultimate factor is your risk tolerance for fluctuations in interest rates. Let's briefly review both options, including how they are determined, and explore their respective advantages and disadvantages.

Floating interest rate:

Provides a typically lower, but variable rate which can fluctuate in response to changes in market interest rates and economic conditions.
Floating interest rates offer flexibility for borrowers who are comfortable navigating market-driven changes and anticipate potential decreases in interest rates.
Floating interest rates are commonly tied to the short-term prime rate or TIBOR, representing the most favorable lending rate applied by banks to creditworthy companies for short-term loans of one year or less.

Fixed interest rate:

Offers borrowers a stable and unchanging interest rate for a predetermined period, typically established at a rate higher than the floating rate, allowing for predictability over the duration of the term
Deployed from 2-years to the entirety of the loan, borrowers benefit from the assurance that their interest rate will remain constant, unaffected by fluctuations in market interest rates or economic conditions. This stability offers a predictable monthly repayment amount acts as a safeguard against potential interest rate increases during the specified duration, making it easier for borrowers to budget and plan their finances.
Typically determined by the 10-year JGB, with the interest rate increasing for longer fixed periods.

Financial institutions may adjust the displayed interest rate based on contract terms, examination results and their added margin or spread, with the reduction amount varying depending on the borrowing period and contract plan. The resulting interest rate after the adjustment is the "applicable interest rate" during the actual borrowing process.

Pros & Cons of Floating and Fixed Interest Rates

Risk Mitigations when choosing a floating rate

If you find it challenging to cope with fluctuations in interest rates or repayment amounts or feel uneasy about such uncertainties, you may not be well-suited for variable interest rates. Mortgage repayment durations can span up to 35 years, and enduring concerns about interest rate trends over such an extended period can pose mental strain. However, there are ways to seek stability and manage risk through these additional clauses and strategies:

“Fixed” for the initial 5 years:

Depending on the banking institution and loan structure, you may be offered a guaranteed rate for the initial 5 years where you can enjoy stability for an initial period and at a lower rate. However, after this initial period, the interest rate becomes variable and adjusts periodically based on market interest rates, usually reviewed every six months.

125% cap:

Depending on the banking institution and loan structure, you may be offered a safeguard of 125% to limit the potential increase. This rule sets a cap on how much the interest rate can change over a specified period, typically each 6-month adjustment period, or annually. This cap provides borrowers with a degree of protection against sharp and sudden increases in interest rates, offering a balance between the benefits of a floating rate and the desire for some level of predictability.

Floating-Fixed Hybrid:

Also known as combination or split loans, provide borrowers with a balanced mix of stability and potential cost savings. This innovative structure divides the loan into fixed and floating components, offering the assurance of predictable repayments for the fixed portion while allowing the floating segment to fluctuate with market conditions. Commonly configured with a designated percentage for each type, such as 70% fixed and 30% floating, these loans enable borrowers to benefit from both fixed-rate security and the potential advantages of floating rates, providing a flexible solution tailored to individual risk tolerance and market dynamics.

Refinancing:

Floating rate offers flexibility in the form of refinancing, providing strategic options to navigate changing interest rate landscapes. One avenue is refinancing to a lender with a lower interest rate or change to a fixed rate. In response to upward trends in interest rates, you can proactively manage your financial exposure and if necessary, transition from a variable to a fixed rate type while rates are favorable or extending the fixed period.

Consider the screening process and associated expenses, such as administrative fees and registration-related charges, when evaluating the financial benefits of refinancing against potential risks posed by interest rate fluctuations.

Summary & Recommendations

Risk Tolerance and Financial Situation:

Begin by evaluating your risk tolerance and financial standing. If prioritizing stability is crucial, fixed rates may be the preferred option. For those attracted to initial cost savings, exploring variable rates or a hybrid approach could be advantageous.

Loan Duration:

Consider the duration of the loan. For long-term loans, the reliability of fixed rates might outweigh potential savings, particularly in an environment with rising interest rates.

Market Conditions:

Stay abreast of market conditions and economic forecasts to make well-informed decisions that align with broader economic trends, ensuring your choices are in sync with the prevailing financial landscape.

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