Basis Points Explained
A basis point is a standard measurement used to define changes in interest rates. Basis points are applicable in numerous financial settings, including the stock market and consumer debt, like student or personal loans. 100 basis points is equal to 1%.
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The world of finance is littered with industry-specific lingo that, for everyday consumers and investors, is often downright confusing. It can seem like the only people who really understand it all are the hedge fund managers.
Unfortunately, without a solid understanding of some of the frequently used terms, borrowing, investing and investment strategies, and planning your financial future can be difficult.
Among the “huh”-worthy words that you may come across in your financial endeavors is the “basis point,” a universal term that is used to define interest rate units.
The term basis points, also referred to as “bps” or “bips,” is used in a variety of financial settings, including for Wall Street financial instruments like shares in the stock market, exchange-traded funds (ETFs) and mutual funds, and Treasury notes but many consumers first come across the term when dealing with debt, including but not limited to student loan debt.
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What is a Basis Point?
So, what is a basis point and why is it so important? A basis point (bps) is a unit of measurement that is used to define interest rate fluctuations. Much like the penny represents 1/100 of a dollar, a basis point is 1/100, or .0001, of a percentage point (1%). As such, 0.01 percent is equal to one basis point, and there are one hundred basis points in 1 percent.
As a unit of rate change, a basis point can be specific to the stock exchange, like when an index rises or falls; it can also refer to bond yields or can be used to describe an interest rate increase or decrease for consumer debt, like personal or student loans.
For example, if you were following the stock market and the index increased by a 150 basis point increase in a single day, then that would translate to a 1.50% percentage change increase.
Basis Points and Student Loans
You may not be playing the stock market, following the Federal Reserve or participating in the bond market, but if you have private student loans, it’s likely you’re more familiar with basis points than you think.
An excellent example, particularly when it comes to school loans, is the discount applied for signing up for autopay or making a specified number of on-time payments.
For instance, many lenders will offer borrowers a deduction of 25 bps if they opt to have their monthly payment auto-deducted from their checking account. In this case, the 25 bps translates to a .25% discount. On an interest rate of 6.15%, the 25-bps reduction would result in a new annual percentage rate of 5.90%. This percent change can be significant.
Converting Basis Points to Percentage Points
Though basis points may seem complicated, converting a basis point to a percentage point is quite simple. If your lender told you that your interest rate would be decreased by 10 bps for making on-time payments, then the easiest way to convert that to a percentage point would be to divide the basis point amount by 100. In this case, 10 bps would be equal to 0.10 percent. It’s an easy way to calculate the basis point change.
Conversely, if you want to determine the bps of a percentage point, then you can do so by either multiplying the percentage by 100 or simply moving the decimal point two places to the left. In this situation, .25% would equate to 25 bps.
Though a basis point may seem like a foreign term, if you’ve ever received a rate reduction or increase, it’s likely that the root of that fluctuation was based on a basis point. Next time you see a bps referenced, simply divide it by 100 and you’ll quickly find the percentage equivalent, allowing you to easily understand how it will impact your debt or investment.
>> Read More: How do student loans work?
Author: Jennifer Lobb