A Guide To Basis Points
Melissa Brock3-minute read
December 14, 2020
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?
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? Basis points, also called bps (which sounds like "bips”) are a unit of measure used to describe the interest rate changes in a financial instrument. One basis point equals 0.01%, or 0.0001. One hundred basis points equals 1%.
How does this translate to mortgages?
Let’s say you have an adjustable rate mortgage (ARM). Your interest rate is 3.50%, then the interest rate changes to 3.75% at a later date. This means your interest rate rose by 25 basis points.
How Do Basis Points Work In Mortgages?
Changes in basis points can impact your monthly mortgage payments, depending on what type of mortgage you have.
When the interest rate goes up, your monthly mortgage payment goes up. Your interest rate is the percentage you pay to borrow money from a lender for a specific period of time.
If your mortgage rate is variable, which is the case with adjustable rate mortgages (ARMs), this means your interest rate might change depending on market rates.
ARM payments may increase at adjustment dates and basis point hikes will affect your principal amount (the amount you owe) and your interest rate.
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.
Why Does The Difference Of One-Hundredth Of A Percent Matter?
Basis points help clarify discussions about interest rates. 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 increases from 4% to 5%.
In addition, 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 3.50% 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).
Paying attention to basis points – even tiny numbers – can help you save a lot of money when you’re buying a home.
How To Calculate Basis Points
Now, let’s break down the steps of how to manually calculate basis points.
To convert basis points to percentages, convert the basis points into a decimal first. One basis point is equivalent to 0.0001, so multiply the number of basis points by 0.0001.
You can compute the basis points as a percentage by multiplying the basis points (let’s use 250) by 0.0001 (250 × 0.0001 = 0.025). This 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 form by dividing it by 100: 2.5/100 = 0.025. Then, divide this figure by 0.0001 and you get 250 basis points.
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.
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.
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