Basis Points Explained
Interest rates are an important part of every student loan since they are key factors into the overall cost of obtaining a loan. Since understanding student loans primarily falls on gaining a mathematical perspective, one must learn the system of measure pertaining to student loan interest rates, as well as general interest rates. A key component to understanding interest rates is viewing how the rates themselves are based. In other words, what underlying system defines interest, or more specifically, what the units associated with interest rates are.
Interest rate units are defined as basis points, and a basis point is one hundredth of a percentage point. When looking at a student loan interest rate, “1 basis point” translates to “0.01%;” therefore, “1%” equals “100 basis points.” The abbreviation “bps” or "bips" is often used when referring to basis points. Basis points serve as the unit of measure in any loan situation, but how do they measure up with student loans?
How do basis points relate to student loans?
The central unit of measurement in the lending world is the basis point. You may see lenders offer a “50 bp reduction” as an incentive for signing up; this essentially means that the lender will lower your loan’s present interest rate by 0.50%. For example, a borrower with a 2.49% interest rate receiving a reduction of 50 bps would now see an interest rate of 1.99%. This term is commonly used to quote interest rates, specifically for variable-rate loans.
An example of this is a L+25, which represents a “1-month LIBOR with 25 added basis points.” This indicates that a rate is built based on whatever the current LIBOR rate is with 25 added basis points. Basis points are commonly used for such situations, and they serve as somewhat of a euphemism for the real numbers as well as a simplification. Claiming a 50 bps reduction in a student loan interest rate sounds fairly enticing compared to hearing .50% in reduction. While this may be true, there still is a twofold purpose for basis points which involves the simplifying aspect; for instance, student loan interest rates are altered in small amounts which makes for a tedious number game. Basis points circumvent this issue and create easy to use whole numbers for convenience.
How do basis points translate to general investments?
Using the principal of 1 basis point equaling .01% is consistent throughout all investments from stock yields or student loans. In reality, when talking about basis points, there is no special application when it comes to student loans because they are a standard unit of measure for all types of investments with interest rates. Therefore a “50 bp increase” on a stock that earns 5.49% pushed the stock’s yield up by .50%, resulting in a total yield of 5.99%. As previously stated, this application of basis points does not vary between student loans interest rates or other types of interest rates.
How do I convert basis points to percentage points and vice-versa?
When thinking about the basis point system overall, the simplest way to convert these units is to simply move the decimal place twice in either direction when converting between a basis point and a percentage point. When starting with a percentage point, move the decimal place to the right two places to convert to a basis point; contrarily, move the decimal place to the left twice to convert a basis point into a percentage point. The system is closely aligned with simple metric conversion system, but this conversion factor is constant and does not vary. This is one simple way to convert basis points and percentage points, but there is another easy way as well. Taking a percentage point and multiplying by 100 converts that value into a basis point, and on the other hand, taking a basis point and dividing by 100 converts that unit into a percentage point.