What Are Basis Points And How Do They Work?

If you've ever tried to measure return on investment or interest paid, you know that if the dollar amounts get high enough, the smallest changes can make a big difference. When looking at different investment options, or speaking of a mortgage interest rate, a trader or a banker might talk about basis points. This article will go over what they are and why they’re important.

What Is A Basis Point (BPS)?

Basis points, also known as BPS (pronounced “bips”), are a unit of measurement that tracks the percentage change of financial instruments, such as interest rates, indexes or benchmarks. One basis point signifies one-hundredth of a percentage point or 0.01%.

Any index or financial institution that measures performance based on percentage change uses basis points, but here’s a nonexhaustive list of examples:

• The London Interbank Offered Rate (LIBOR) and its presumed U.S. successor, the Secured Overnight Financing Rate (SOFR)
• Mutual funds
• Fixed-income securities
• The federal funds rate set by the Federal Reserve
• Interest rates
• Performance of the stock market and individual stocks

How Does A Basis Point Work?

A basis point is used to describe changes in the performance of various financial instruments. Because basis points describe a percentage change as minimal as 0.01%, you can describe small or large changes in things like interest rates without the need for the mental gymnastics used to deal with fractions or decimals.

To get a better idea of how they work, see this conversion table.

If you’re looking to understand just how small a basis point is, it takes 100 of them to make up 1%. However, when you start talking in terms of dollars and cents, these can make a big difference. We’ll have an example of the impact even a slight difference can have on your mortgage later on.

How To Calculate Basis Point Conversions

To better understand the way the math works, let's run through some quick story problems. I know that reminds you of math class. Don’t worry. This won’t be on the test.

Your Home Loan Expert tells you interest rates have moved up 10 basis points in the last 2 days. What’s the percent difference?

In order to convert from basis points to a percentage, you divide 10 by 100. If you don’t have a calculator, just move the decimal two places to the left.

10

___ = 0.1%

100

Now let’s say you’re tracking the stock market and you read that the stock market is up 0.5% on the week. What would that be in terms of basis points?

In order to come to the answer, you multiply 0.5 by 100. You can also move the decimal point two places to the right.

0.5 × 100 = 50

Why Are Basis Points Important?

Basis points are useful in that they give investors and consumers alike a common vocabulary to speak about small changes that can have a big impact. How big? Let's take a quick look at a mortgage example.

You're looking to apply for a $250,000 30-year fixed mortgage at an interest rate of 3.5%. The monthly payment would be $1,122.61 excluding taxes and insurance. Total interest paid is $154,140.22.

If we take the same loan amount with an increase of a single basis point to 3.51%, the monthly payment becomes $1,124.01. While the monthly payment doesn’t go up that much, total interest paid is $154,642.78, meaning you’re going to pay $502.56 more over the life of the loan. Check out our amortization calculator to try your own mortgage numbers.

As you can see, small differences can mean hundreds or thousands of dollars depending on the size of your loan or the amount of your investment. This will give you context when you're comparing loan offers or evaluating the historical performance of a certain hedge fund before deciding to invest. You'll be able to do the math and apply it to your situation.

The Bottom Line

Basis points are units used in financial measurements equal to 1/100 of 1%. This enables traders, investors and the public to speak about minuscule changes in things like interest rates without having to resort to fractions or decimals. Knowing how to talk about and calculate them enables you to understand and be an active participant in your finances.

If this understanding has helped you feel more comfortable with the mortgage rates you see and you're in the market to purchase or refinance a home, you can apply online or give us a call at (888) 452-0335.