Introduction to Finance

term structure of interest rates 
relationship between interest rates 
and the time to maturity for debt 
instruments of comparable quality
yield curve 
graphic presentation of 
the term structure of interest rates at 
a point in time
Home Mortgages
Interest rates on home mortgages are aff ected by the infl uences 
discussed in this chapter. A typical 30-year fi xed-rate mortgage 
incorporates the factors that aff ect a 30-year Treasury bond (real 
rate + infl ation expectations + maturity risk premium + liquidity 
premium) in addition to these other infl uences, such as default 
risk premium (since the typical homeowner is a higher risk than 
the U.S. government) and security premium (this helps lower the 
mortgage interest rate, since, in case of default, the lender can 
take possession of the borrower’s house and sell it to recoup the 
amount lent). Homeowners can play the short end of the term 
structure, too. Adjustable-rate or variable-rate mortgages rise 
and fall in line with a specifi ed short-term interest rate, usually a 
Treasury security. The interest rate paid by the homeowner equals 
the short-term rate plus a premium, to refl ect the homeowner’s 
higher degree of default risk. The danger of buying a home with 
an adjustable-rate mortgage is that an infl ation scare or some other 
reason may cause a rapid rise in short-term rates, whereas the rate 
on a fi xed-rate loan does not fl uctuate. Since short-term rates usu-
ally are less than long-term rates, an adjustable-rate mortgage is 
an attractive fi nancing possibility for those willing to take the risk 
of fl uctuating short-term rates or those who expect to own their 
home for only three to fi ve years before they move out of it.
Personal Financial Planning

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204
C H A PT E R 8 Interest Rates
due to concern about an economic downturn and the terrorist attack in New York City on 
September 11, 2001. By November 2001, one-year Treasury interest rates had dropped to 
about 2 percent. Short-term interest rates continued to fall and were at about 1 percent in 
November 2003. However, in an eff ort to keep infl ation under control, the Fed forced short-
term interest rates higher in recent years so that one-year rates reached about 5 percent in 
October 2006. 
The Fed moved quickly in 2008 to help avoid a collapse in the fi nancial system by fi rst 
using its traditional open-market operations to increase monetary liquidity by purchasing 
government securities. Then, as previously noted, the Fed engaged in a new nontraditional 
monetary policy action termed quantitative easing (which became known as QE1) in late 
2008 in response to the 2007–08 fi nancial crisis and the 2008–09 Great Recession. As Table 
8.3 shows, the yield on one-year Treasury securities declined to 0.4 percent by October 
2008. By late 2008, the Fed had reduced its target for the federal funds rate to 0.00–.0.25 
percent. Because of a relatively slow economic recovery from the Great Recession, QE2 
was implemented by the Fed in late 2010. QE3 followed in late 2012. As a result of massive 
monetary easing eff orts, the interest rates on Treasury securities were forced to historical 
lows as shown in Table 8.3. The rate on one-year Treasury bills was only 0.16 percent and 
even fi ve-year Treasury securities were yielding only 0.72 percent at the end of December 
2012. Interest rates on short-term Treasury securities increased in late 2015 in response to 
the Fed increasing its near-zero federal funds target interest rate, which had been in place 
since late–2008, to 0.25–0.50 percent.