Basis points (BPS): A complete guide

No matter your familiarity with financial terminology, it’s a good idea to understand the basics of basis points. Basis points are important because 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 taking out a mortgage to buy a house.

Here’s everything you need to know about basis points, including the basic definition and how to calculate them.

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, bond yields or financial ratios in U.S. Treasury bonds, mutual funds, exchange-traded funds (ETFs) 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.

If you’re in the market to buy a house, you’ll likely come across basis points in discussions about your mortgage interest rate. If your interest rate increases or decreases by basis points, your monthly mortgage payment will also change.

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 is equal to 1%.

Why are basis points used instead of percentages?

Basis points, like percentages, measure numerous financial instruments (like bonds, stocks, mortgage loans, etc.), which can impact economic growth. But unlike percentages, which can be easy to confuse for those who don’t regularly speak finances, they create a common language that is easy to understand. It’s common to think that 0.1% is a negligible amount when it comes to an interest rate, but when you hear “10 points,” it sounds more significant.

For instance, when interest rates increase, even if it's only by a few points, those points represent an enormous amount of money. This increase can then affect the mortgage industry, credit card rates and other financial instruments.

How are basis points calculated?

Now, let’s break down the steps for calculating basis points manually. The first thing to remember when calculating basis points is that one basis point equals 0.01%, or 0.0001. That means:

• When converting basis points to percentages, multiply by 100.
• When converting percentages to basis points, divide by 100.

Basis points example calculation

Let’s consider an example with a step-by-step calculation. In the example below, the interest rate rose 250 basis points in 1 year – from a baseline interest rate of 5.5% (or 0.00055). What is the new interest rate?

To find out, remember that one basis point equals 0.001.

1. Multiply 250 by 0.0001 (250 × 0.0001 = 0.025) to get 0.025.
2. Add that to the baseline interest rate (0.00055) to get the new rate: 0.0008.
3. Multiply that number by 100 and you get the percentage, which equals a new interest rate of 8%.

In this example, if a loan had a 5.5% interest rate and it increased 250 points, the loan’s interest rate would now be 8%. Keep in mind, this kind of rate jump doesn’t happen at once. It usually takes a few rate hikes (each by a quarter or half percent, typically) over an extended amount of time for a rate to rise 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 of 2.5%.

1. Convert 2.5% to a decimal by dividing it by 100. The calculation is 2.5 ? 100 = 0.025.
2. Then, divide this figure by 0.0001 to get 250 basis points.

How do basis points work in mortgages?

Depending on your mortgage type, changes in basis points can impact your monthly mortgage payments. Your mortgage 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.

If your mortgage rate is variable, which is the case with adjustable-rate mortgages (ARMs), 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. Let’s say that you have an ARM with an interest rate of 7.5%, then the interest rate changes to 7.75% 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 mortgage rate. If you don’t, you could pay basis point hikes in the form of a higher interest rate.

How to use basis points

Basis points evaluate small changes to interest rates or yields. The Federal Reserve (Fed) 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
• Mutual funds
• ETFs
• Credit derivatives
• Options and futures
• Debt securities
• Equity securities
• Credit cards
• Savings accounts

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?

It’s important to know that your monthly payments will only change if you have a specific type of mortgage: an ARM. Any payments you make on a fixed-rate mortgage will always remain the same.

All rate changes will depend on your loan terms. Check with your lender for exact information about how your payments will change.

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 interest rate can mean tens of thousands of dollars over the life of the loan.

Let’s say you’re looking at a $200,000 home with a 30-year loan term and a 7.5% interest rate. If you make a 20% down payment on the house, your mortgage payment would be $1,119 (without taxes and insurance). You would pay $242,747.56 in total interest.

If your interest rate was 25 basis points more – 7.75% – then your payment would jump to about $1,146 (excluding taxes and insurance). You would pay $252,653.45 in total interest – almost $10,000 more.

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 on basis points

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.

Are you getting ready to buy a house? Take the next step in the home buying process and start your mortgage application today.