Basis Points Defined: How They Work And How To Calculate

If you’re considering buying a house and taking out a mortgage, chances are you’ll come across the concept of basis points sooner or later. Basis points are a simpler way to represent the ever-fluctuating, precise changes of financial instruments such as interest rates, stocks and bonds.

Knowing how basis points work and how to calculate them can benefit you greatly during the homebuying process. In this article, we’ll briefly discuss what basis points are and why they’re so important.

What is a Basis Point?

Basis points, often abbreviated as “bps” or “bips,” are units of measurement that track the performance of various financial instruments, including interest rates. One basis point is equal to one one-hundredth of a percentage point, or 0.01%. In other words, 50 basis points equal 0.50%, and 100 basis points equal 1%.

When it comes to mortgage loans, basis points are used to reflect changes in interest rates – which can affect your future monthly mortgage payment. Mortgage payments can either increase or decrease according to the market rates.

Say for example, you have an adjustable-rate mortgage (ARM) with a mortgage rate of 6.5%, then the interest rate rises to 7%. This means your interest rate rose by 50 basis points, and your mortgage payment will subsequently increase.

How Do Basis Points Work?

Unless you’re a math whiz, it may be mentally taxing to calculate extremely small or large changes using percentages or decimals. This is when basis points come in handy.

 For instance, one basis point is equivalent to 0.01% or 0.0001 in decimal form. It’s much easier to summarize a change that small using basis points. Rather than saying that an interest rate increased by 0.01%, you can simply say it rose by one basis point.

Also, since basis points are clearly defined units of measurement, using them can help to avoid ambiguity and confusion when discussing such precise figures.

The conversion table below provides a better understanding of how basis points work.

How To Calculate Basis Points

To calculate basis points, you’ll need to remember that one basis point equals 0.01%, or 0.0001.

If you want to convert basis points to percentages, divide by 100 (or move the decimal point two places to the left).

Percentage (%) = Basis points (BPS) / 100

When converting percentages to basis points, multiply by 100 (or move the decimal point two places to the right).

Basis points (BPS) = Percentage (%) x 100

Seems simple enough, right? Let’s practice with two quick scenarios.

Your Home Loan Expert tells you that interest rates have increased by 25 basis points. What’s the percent difference?

25 BPS / 100 = 0.25%

Now let’s say that interest rates are up 0.5% this week. What would that be in terms of basis points?

 0.5% x 100 = 50 BPS

When Are Basis Points Used?

Financial institutions use basis points to track percentage changes to a number of financial instruments – and this can affect your personal finances in many ways.

Financial instruments that use basis points include:

 

Why Are Basis Points Important?

Basis points are important because they give investors and consumers a shared language to speak about small, but potentially impactful changes. Such changes don’t just influence the overall economy, but they can also impact your personal finances. For example, when interest rates increase, you could end up paying more for your mortgage.

Say you’re looking to apply for a $250,000 30-year fixed mortgage at an interest rate of 6.5%. Without taxes and insurance, the monthly payment would be $1,580.17. Total interest paid is $318,861.22.

Now, if the same loan amount increased by one single basis point to 3.51%, the monthly payment becomes $1,581.81. True, the monthly payment didn’t go up much. However, the total interest paid is $319,453.24, meaning you’ll end up paying $592.02 more over the life of the loan.

Seemingly small differences can mean hundreds or thousands of dollars depending on your specific loan terms. This is why it’s so important to make an informed decision.

FAQs On Basis Points

Here are the answers to some frequently asked questions about basis points.

Why use basis points instead of percentages?

Very small or large changes in percentages can become quite complicated, thus leaving room for error and confusion. Using basis points instead of percentages helps lessen the possibility of ambiguity and misunderstandings that could arise.

How much is 50 basis points?

One basis point equals one one-hundredth of a percentage point, or 0.01%. So then, 50 basis points equals 0.5 percentage points, or 0.5%. In practical terms, say that the Fed raised interest rates from 3.78% to 4.28%, this would mean that interest rates rose by 50 basis points.

How much is 100 basis points?

100 basis points indicates a 1% change in interest rates. For instance, if interest rates increase from 4.5% to 5.5%, you could simply say they rose by 100 basis points.

What does BPS stand for?

BPS is a common abbreviation for basis points, and BP for basis point. You’ll hear this abbreviation pronounced as “bips.” A basis point is a common unit of measurement for changes in financial instruments such as interest rates, stocks and bonds.

The Bottom Line

Basis points are a unit of measurement that make it easier to discuss changes in financial instruments like interest rates without having to use fractions or decimals. One basis point is equal to 1/100 of 1%. Understanding how they work and how to calculate them can empower you to make informed financial decisions.