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What is a basis point?
A basis point represents the smallest unit of measurement for interest rates and other financial instruments. One basis point is equal to one-hundredth of 1 percent, or .01. Basis points are also referred to in the financial world as BPS, “beeps,” or points. It takes 100 basis points to get 1 percentage point.
The Federal Reserve uses basis points when changing interest rates or lending money. Basis points provide a way for the Fed to exert a finer control over the interest rates they manipulate to help control the U.S. economy.
Basis points also are used by portfolio managers and investors to trade in U.S. Treasury bonds, mutual funds and exchange-traded stocks.
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Basis point example
In its efforts to keep the U.S. economy stable and growing, the Federal Reserve controls interest rates, making it more or less expensive to borrow money and influencing the returns on bank deposit products such as savings and money market accounts and certificates of deposit. This is done in an effort to control inflation and keep prices from skyrocketing.
The Fed uses basis points to make changes in the federal funds rate, which is the interest that banks charge each other to borrow money overnight. If the Fed raises the federal funds rate by a quarter of a percentage point, that’s equal to 25 basis points. The federal funds rate influences the prime rate. So, if the prime rate is 4 percent and the Fed raises the federal funds rate by 25 basis points, the prime rate will rise to 4.25 percent.
This affects the cost of mortgages and credit card rates, for example. Incremental changes in the cost of borrowing, in the form of basis points, have a big impact on the overall economy.