Basis points versus percentages
Basis points and percentages are not the same, but they convey the same information. This is why they can be very confusing for people. As in the example above, 0.25% is the same as 25 basis points, but if it's easier to say 0.25%, why not just do it?
The truth is that it's about clarity. If you say that the 5.5% federal funds rate is about to increase by 0.25%, that might imply that the rate will be added together to get 5.75% (5.5% + 0.25%) or that it's growing 0.25%, essentially multiplying 5.5% by 1.025% to get 5.6375%. It's not a huge difference, but it's enough to create serious inaccuracies.
However, if you say that the 5.5% federal funds rate was raised by 25 basis points, that's simple. There's clarity. That's 5.75%, always and forever.
How basis points are used
Because basis points provide more clarity than using multiple different percentages in the same sentence, they're generally how increases and decreases in interest rates are expressed. This might be anything from a change in a mutual fund rate to an increase in the 30-year fixed mortgage rate.
For example:
- Your mutual fund saw an increase in interest of 3 basis points.
- The 30-year fixed mortgage rate rose by 25 basis points this month.
- The federal funds rate was dropped by 25 basis points for the first time in a year.
Using basis points also adds a lot of precision to a conversation, because it's a much smaller unit that's easier to express. When was the last time you said that your mutual fund gained 0.03% interest? Probably never -- that's a heck of a mouthful!
The tendency for people to round trailing decimals is very strong and it can create a lot of chaos when talking about fractions of percentages. So, instead of trying to discuss 0.03% of something, we just call it 3 basis points. Psychologically, it's a whole number, even though we know it represents a fraction of a percent.
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