Introduction
If you’re new to the world of finance, you may have come across the term “basis points” and wondered what it means. In simple terms, basis points are a way of measuring the percentage change in interest rates or investment returns. In this article, we’ll take a closer look at what basis points are, how they’re used, and why they matter.
What are Basis Points?
Basis points, abbreviated as “bps,” are a unit of measurement commonly used in finance. One basis point is equal to one-hundredth of a percentage point, or 0.01%. For example, if the interest rate on a loan or investment increased by 25 basis points, it would mean the rate increased by 0.25%.
Why are Basis Points Used?
Basis points are used because they provide a more precise way of measuring changes in interest rates or investment returns. When dealing with large sums of money, even small changes in percentage points can have a significant impact. By using basis points, investors and lenders can accurately communicate and measure these changes.
How are Basis Points Calculated?
To calculate basis points, you simply divide the percentage change by 0.01. For example, if the interest rate on a loan increased from 5% to 5.25%, the percentage change would be 0.25%. Dividing 0.25% by 0.01 gives you 25 basis points.
Why Do Basis Points Matter?
Basis points matter because they can have a big impact on your finances. For example, if you have a mortgage with an interest rate of 4% and the rate increases by 100 basis points, your monthly payment could increase significantly. In the world of investments, even small changes in returns can have a big impact on long-term gains.
Examples of Basis Points in Action
Let’s say you have a savings account with an interest rate of 1%. If the bank increases the rate by 25 basis points, your new rate would be 1.25%. If you have $10,000 in your account, the increase would mean an extra $25 in interest per year. Similarly, if you have a loan with an interest rate of 6%, and the rate decreases by 50 basis points, your new rate would be 5.5%. If you owe $100,000 on the loan, the decrease would save you $500 per year in interest payments.
How to Use Basis Points
Basis points can be used in a variety of ways, from negotiating interest rates on loans to comparing investment returns. When shopping for loans or credit cards, knowing how to calculate basis points can help you understand and compare different offers. When investing, understanding basis points can help you make informed decisions about which stocks, bonds, or mutual funds to choose. By comparing the returns of different investments in basis points, you can get a clearer picture of which ones are performing better.
The Bottom Line
Basis points may seem like a small detail, but they play a big role in the world of finance. By understanding how basis points work and how they’re used, you can make better financial decisions and stay on top of changes in interest rates or investment returns. So the next time you come across the term “basis points,” you’ll know exactly what it means and why it matters.
