In finance, a basis point spread represents the gap between two interest rates or yields, measured in basis points (bps). One basis point equals 0.01%, or one one-hundredth of a percent, making it a useful unit for discussing small changes in rates precisely. The spread itself is simply the numerical difference between these rates, converted into basis points for clarity.
For example, if one mortgage lender offers you an interest rate of 6.85% and another offers 6.60%, the difference is 0.25%. Converting this to basis points, where 1 bps = 0.01%, means the basis point spread is 25 bps.
Understanding basis point spreads is critical when comparing loan offers, bonds, or any financial instruments where interest rates play a role. A small spread can translate into significant cost savings or additional returns, especially on large principal amounts or over long periods.
How Basis Points Work
A basis point is one-hundredth of a percentage point (0.01%). This unit avoids confusion when discussing interest rate changes. For instance, an increase of 25 bps means a 0.25% rise in the rate.
Why Spreads Matter
The “spread” denotes the difference between two rates. In loans, a lower spread between offers means better borrowing costs. In investments, especially bonds, the spread indicates risk premium — the extra return investors demand to compensate for additional risk compared to safer investments like U.S. Treasury bonds.
Real-World Applications
- Mortgages and loans: A 25 bps difference on a $400,000 mortgage might save thousands over the loan term.
- Bonds: Comparing yields between corporate bonds and Treasury bonds shows the risk investors associate with lending to corporations.
- Monetary Policy: Central banks like the Federal Reserve announce rate changes in basis points to provide precise communication to markets.
Economic Signal and Risk Indicator
Widening spreads can indicate increased risk or economic uncertainty, while narrowing spreads suggest improving conditions.
Key Takeaway
Never underestimate small basis point differences — they can have a significant financial impact over time. Doing simple math to understand what these differences mean in dollars or returns helps make smarter financial decisions.
For more on interest rates and how they affect loans, see our glossary term LIBOR Rate.
References:
- Investopedia, “What Are Basis Points (BPS)?” https://www.investopedia.com/terms/b/basispoint.asp
- ConsumerFinance.gov, “What is a basis point?” https://consumerfinance.gov/ask-cfpb/what-is-a-basis-point-en-1931/
- Federal Reserve Economic Data (FRED), https://fred.stlouisfed.org/series/FEDFUNDS
(Optional external link for authority: IRS on Interest and Dividends)
