[Special Feature] The Full-Scale Arrival of a 'World with Interest Rates' in Home Loans and the Pitfalls of the '5-Year/125% Rule'

~Defensive techniques to question the myth of fixed variable interest rates and prepare for the risk of unpaid interest~

Domestic long-term interest rates (10-year Japanese government bond yields) have risen to levels approaching the 3% mark, and a full-scale ‘world with interest rates’ has taken root in the Japanese financial market.

And now, the wave of base interest rate hikes is surely surging toward ‘home loans,’ which have enjoyed the benefits of ultra-low interest rates the most. Many people are likely starting to feel anxious about future repayments after seeing interest rate revision notices from their financial institutions.

If you have a loan balance of 40 million yen, a mere 1% increase in interest rates will result in an additional annual interest burden of approximately 400,000 yen. Converted to a monthly basis, this is an increase of over 30,000 yen, which is by no means an amount that a household can ignore.

However, many of those who have actually checked their monthly withdrawal accounts tilt their heads in confusion.

“The interest rate should have gone up, but my monthly repayment amount hasn’t changed by even one yen. Is the impact not as significant as all the fuss suggests?”

If you are feeling relieved right now, that may be a sign that you have stepped into the ‘greatest trap’ built into the financial product known as a home loan.

The reason your monthly repayment amount hasn’t changed is not because your burden hasn’t increased, but simply because the institutional ‘cushion for drastic changes’ has been activated, and the pain is merely being deferred to a place where it is not visible.

In this issue’s special feature, we will unravel the mathematical mechanisms of the ‘5-year rule’ and ‘125% rule’ that many variable interest rate users blindly trust, and logically examine the ‘debt control techniques’ we should adopt in a world with interest rates.

Part 1: First, understand the mechanism – Short-term prime rate linkage and the ‘two rules for mitigating drastic changes’

To eliminate emotional arguments and vague anxieties, let’s first objectively review the structure of variable interest rate determination and the mechanism of the safety net that keeps repayment amounts constant.

1. How are variable interest rates determined?

In many cases, variable interest rates for home loans are linked to the ‘short-term prime rate,’ which is the base interest rate that banks use when lending to high-quality companies on a short-term basis.

Because the short-term prime rate is strongly influenced by the Bank of Japan’s policy interest rate (the uncollateralized overnight call rate), if the Bank of Japan raises interest rates, the short-term prime rate rises, and the ‘base interest rate’ for home loans is raised accordingly.

The applicable interest rate we actually pay is this base interest rate minus the ‘preferential margin (reduction margin)’ promised at the time of the contract. Since the preferential margin itself generally does not change until the loan is paid off, our applicable interest rate rises directly by the amount that the base interest rate increases.

2. The ‘5-year rule’ and ‘125% rule’ that prevent sudden changes in household finances

Why does the monthly withdrawal amount not change even though the interest rate has been raised? This is because there are ‘two safety devices’ equipped in standard principal-and-interest equal repayment home loans.

• ① 5-year rule (deferral of repayment amount)
  Although interest rate revisions themselves are usually carried out ‘twice a year (such as in April and October),’ the monthly repayment amount (the sum of principal and interest) is subject to a rule that it is ‘deferred for 5 years.’ No matter how sharply interest rates soar, the monthly withdrawal amount will not increase for the next 5 years.

• ② 125% rule (upper limit for repayment amount increase)
  When 5 years have passed and the monthly repayment amount is revised, there is a rule that the new repayment amount ‘can only be increased up to 1.25 times (125%) of the previous repayment amount.’ For example, if the repayment is 100,000 yen per month, no matter how much market interest rates skyrocket, the repayment amount for the next 5 years will be limited to a maximum of ‘125,000 yen per month.’

At first glance, these two rules appear to be ‘kind mechanisms that prevent sudden bankruptcy for consumers.’ However, in the world of finance, there is no such thing as a ‘free lunch’.

This mechanism does not exempt you from the burden of debt; it merely ‘passes the buck to your future self’.

Part 2: The Numerical Trap — The ‘Cessation of Principal Repayment’ and ‘Unpaid Interest’ Progressing Behind Fixed Repayment Amounts

When your monthly repayment amount remains unchanged, what is actually happening in the breakdown (balance sheet)? Let’s verify this with concrete numbers.

1. The Invisible Erosion Known as ‘Cessation of Principal Repayment’

The repayment amount we pay each month is the sum of ‘principal repayment’ and ‘interest payment’.

When interest rates rise, if your monthly repayment amount is fixed by the 5-year rule, the bank performs a calculation process that ‘prioritizes the payment of the increased interest and reduces the amount allocated to principal repayment by that same margin’.

| Item | Before Interest Rate Hike (Ultra-low rate period) | After Interest Rate Hike (When fixed) |
| :— | :—: | :—: |
| Monthly Repayment Amount | 100,000 yen | 100,000 yen (No apparent change) |
| Of which ‘Interest Payment’ | 20,000 yen | 70,000 yen (Significant increase) |
| Of which ‘Principal Repayment’ | 80,000 yen | 30,000 yen (Significant decrease) |

Please look at the table above. While the amount withdrawn from your account is exactly the same 100,000 yen as before, the ‘principal repayment’ intended to reduce the debt itself has plummeted from 80,000 yen to 30,000 yen per month.

Living consumers who only look at their bankbooks feel relieved, thinking, ‘I managed to pay back 100,000 yen again this month,’ but in reality, the principal of the debt has barely decreased.
This is the first pitfall that quietly progresses behind a facade of peace of mind.

2. The Terror of ‘Unpaid Interest’ Where Interest Swells Beyond the Payment Amount

Even more serious is the case where the interest rate hike is large, and the interest that should be paid each month exceeds the set repayment amount (e.g., 100,000 yen per month).

For example, suppose the calculated monthly interest jumps to 110,000 yen.
However, because of the 5-year rule, the bank can only withdraw 100,000 yen from your account. What happens to this ‘10,000 yen difference’ that has overflowed?

Naturally, the bank will not waive it; this unpaid interest is recorded in a separate category as ‘unpaid interest’ and carried over to the following month and beyond.

When this happens, despite paying 100,000 yen every month without fail, you fall into a nightmarish state where not only does the principal not decrease by even one yen, but the unpaid debt snowballs in the background.

3. The ‘Lump-Sum Demand’ Awaiting at the 35-Year Maturity Date

How will the ‘unreduced principal’ and ‘unpaid interest’ that were continuously deferred by the 5-year rule and the 125% rule eventually be settled?

The answer is extremely cold and clear.

You will be ‘required to repay the entire remaining balance in a lump sum on the final maturity date of the loan (e.g., the 35th year)’.

Just as you reach retirement age and are planning to live a peaceful retirement on your severance pay, you will receive a notice on the final withdrawal date stating, ‘Please pay the total of the remaining principal and unpaid interest, amounting to several million to ten million yen, in a lump sum’.

We must correctly recognize the fact that the rule to mitigate drastic changes is not magic to save consumers, but rather ‘a life-prolonging measure like a narcotic that temporarily maintains cash flow during one’s working years at the cost of the risk of bankruptcy in old age’.