A Guide To Basis Points
Victoria Araj3-minute read
November 22, 2022
Whether you’re familiar with financial terminology or have never heard of the term “basis point” before, it’s a good idea to understand the basics of basis points – they can affect your monthly mortgage payments. You may also want to know how they work in the context of interest rate changes when you’re buying a home.
Here’s what you need to know – the basis point definition, how to calculate them and more.
What Is A Basis Point?
Basis points, also called bps (pronounced “bips”), are units of measurement that assess percentages in finance. Portfolio managers and investors use basis points to indicate the percentage change in interest rates or financial ratios in U.S. Treasury bonds, mutual funds, exchange-traded stocks and real estate-based investments.
Professionals use mathematical terms to describe basis points – but even if you’re not a financial analyst or banker, you can understand them, too.
How Much Is A Basis Point?
A basis point is one-hundredth of a percentage point. For instance, one basis point equals 0.01%, or 0.0001. One hundred basis points equal 1%.
How Do Basis Points Work In Mortgages?
Depending on your mortgage type, changes in basis points can impact your monthly mortgage payments. Your interest rate is the percentage you pay to borrow money from a lender for a specific period of time. When the interest rate goes up, your monthly mortgage payment goes up.
ARM payments may increase at adjustment dates and basis point hikes will affect your principal amount (the amount you owe) and your interest rate. Let’s say that you have an ARM with an interest rate of 3.5%, then the interest rate changes to 3.75% at a later date. This means your interest rate rose by 25 basis points.
When you’re searching for a home, it’s a good idea to lock your rate. If you don’t, you could pay basis point hikes in the form of a higher interest rate.
How Are Basis Points Calculated?
Now, let’s break down the steps of how to calculate basis points manually.The first thing to remember when calculating basis points is that one basis point equals 0.01%, or 0.0001. So, to calculate basis points:
- When converting basis points to percentages, multiply by 100.
- When converting percentages to basis points, divide by 100.
Let’s use 250 basis points, for instance. In this scenario, you would multiply 250 by 0.0001 (250 × 0.0001 = 0.025) to get 0.025. Multiply this number by 100 and it equals a basis point percentage conversion of 2.5%.Now, let’s say you’re curious about how an interest rate converts to basis points. In that case, you’ll use the reverse of the above equation. Let’s use the same interest rate – 2.5%.First, convert this to a decimal by dividing it by 100: 2.5 ∕ 100 = 0.025. Then, divide this figure by 0.0001 and you get 250 basis points.
Why Are Basis Points Important?
Basis points are essential because they influence numerous financial instruments (e.g., bonds, stocks, mortgage loans, etc.), which can impact our economic growth. For instance, when interest rates increase, even if it's only by a few points, those points represent an enormous amount of money, which can then affect the mortgage industry, credit card rates and other financial instruments.
How To Use Basis Points
Basis points evaluate small changes to interest rates or yields. The Federal Reserve sets the federal funds rate, which is a benchmark interest rate that influences how much you pay to borrow money.Here are some financial instruments that use basis points to measure percentages:
- Corporate bonds
- Treasury bonds
- Interest rates
- Credit derivatives
- Options and futures
- Debt securities
- Equity securities
Basis Point FAQs
Here are some frequently asked questions regarding basis points and how they work.
How do basis point changes affect my monthly payments?
All rate changes will depend on your loan terms. Check with your lender for exact information about how your payments will change.
Why use basis points vs. percentages?
Basis points help clarify discussions about interest rates and remove the ambiguity around percentages.
For example, let’s say a lender says, “The interest rate increased a percentage from 4%.” What exactly does this mean? Saying “a 100-basis-point increase” explains much more clearly that the interest rate increased from 4% to 5%.
Why does the difference of one-hundredth of a percent matter?
A fraction of a percent doesn’t seem like much, but a hundredth of a point on a mortgage can mean tens of thousands of dollars over time.
Let’s say you’re looking at a $200,000 home with a 30-year loan term. Your mortgage payment would be $718.47 (without taxes and insurance) with a 3.5% interest rate.
A basis point jump to 25 basis points to 3.75% means that your payment would jump to $740.98 (without taxes and insurance). Every month, this extra little bit translates to paying over $8,000 more throughout the loan.
Paying attention to basis points – even tiny numbers – can help you save a lot of money when you’re buying a home.
The Bottom Line
Though basis point changes can seem complex, chances are if you’ve ever received a rate reduction or increase, it’s based on basis points. It’s important to know how they may change your monthly mortgage payments or affect your potential home purchase.
Want to learn more about basis points? Research mortgages to learn which type best fits your needs and visit the Learning Center to understand all aspects of the home buying process.
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