What Are Basis Points and How Do They Affect Your Banking?
When it comes to banking and finances, consumers often think in terms of whole numbers and round percentages — a $25-per-month increase in an adjustable-rate mortgage, or a 2% increase in a bond yield, for example. But those increases often result from very small changes in interest rates or value — often just a fraction of a percentage point. Basis points provide a way to quantify those small changes.
What Are Basis Points?
Basis points are a unit of measure, with one basis point equaling 1/100th of 1%. In the financial world, basis points are used to measure small changes, or spreads, in interest rates and yields. They make it easier to communicate those spreads.
How Do Basis Points Work?
As noted, one basis point equals 1/100th of 1%. One hundred basis points equal 1%.
Here’s what the progression looks like in multiples of 10, with conversions for decimals and percentages:
Basis Points | Decimal | Percentage of 1% |
|---|---|---|
1 | 0.0001 | 0.01% |
10 | 0.001 | 0.10% |
100 | 0.01 | 1% |
1,000 | 0.10 | 10% |
10,000 | 1.0 | 100% |
To convert basis points to percentages and vice versa, use an online basis-points calculator or follow these formulas:
To convert basis points to a percentage, divide the basis points by 100. For example, 50 basis points ÷ 100 = 0.50 (50%).
To convert a percentage to basis points, multiply the percentage by 100. For example, 0.50 x 100 = 50 basis points.
While you could describe an increase from $100 to $103 as a 3% increase and everyone would know exactly what you mean, describing a 50% rate increase for a financial instrument yielding 5% gets tricky. It could be interpreted as an increase from 5% to 7.50% (5% plus 50% of 5%, or 2.5%). It could also be interpreted as an increase to 55% (5% plus 50%). Finance professionals would describe the increase more specifically as 250 basis points in the former case, or as 5,000 basis points in the latter case.
Why Are Basis Points Important?
Changes in interest rates and yields can have a profound effect on your banking, and basis points are a good way to describe them. The changes often follow changes to the federal funds rate implemented by the Federal Reserve.
The federal funds rate is a benchmark that indirectly influences the interest rates banks charge on mortgages and other loans, with those rates rising and falling with the federal funds rate. It also impacts yields banks pay on interest-bearing bank accounts such as savings accounts, money market accounts and certificates of deposit.
Banks also use the federal funds rate as a benchmark to set prime rates — the most favorable rates they offer customers with “prime” credit. They use prime rates to calculate annual percentage rates on certain loans and credit cards.
The Fed has implemented 10 federal funds rate hikes since March 2022, when the target rate range was 0.00 to 0.25%. The first increase, which went into effect on March 17, 2022, set the new target at 0.25% to 0.50%. That’s a 0.25% increase, or an increase of 25 basis points. The Fed has implemented nine more increases since then, ranging from 25 to 75 basis points. The current target is 5.00% to 5.25%, or 500 basis points higher than the pre-March 17 range.
How Do Basis Points Affect My Banking?
Even small rate and yield changes make a big difference in the rates you earn and pay.
Savings Account and CD Yields
Rates on savings accounts, money market accounts and CDs all change when the federal funds rate changes.
As of July 17, the average national deposit rate for savings accounts has increased from 0.33% to 0.42% (nine basis points) since the beginning of the year. The average rate for a 12-month CD increased from 1.28% to 1.72% (44 basis points). That doesn’t sound like much, but when you factor in other considerations that affect bank rates, such as the bank’s own policies and competition with other banks, a 44-basis-point increase could translate to a rate increase from 4.50% to 4.94% at an online bank with high-yield accounts. Over five years, a 4.50% rate would yield $2,518 in interest on a $10,000 balance. Add 44 basis points to that yield and it grows by $277.
Mortgage Loans
Basis points affect mortgage rates in several ways.
Say, for example, you’re taking out a $320,000 mortgage loan to purchase a $400,000 home with a down payment of $80,000. The lender offers you a fixed rate of 7% (700 basis points) but will reduce that to 6.75% (675 basis points) if you purchase two discount points — i.e., buy down the interest rate by paying some interest upfront. A point is 1% of the loan amount, so two points would be 2% (200 basis points).
Here’s how basis points affect various factors in each scenario:
To get a 7% rate, you’d pay:
$80,000 down
$2,129 per month
$446,428 total interest
$766,428 total loan cost
To get the 6.75% rate, you’d pay:
$86,400 down ($80,000 plus $6,400 for the points)
$2,076 per month
$427,185 total interest ($433,585 including the points)
$747,185 total loan cost ($753,585 including the points)
Reducing the rate by 25 basis points would reduce your payment by $53 per month ($19,080 over 30 years) and save you $12,843 in interest.
If you have an adjustable-rate mortgage, basis points also affect how much your rate goes up or down when it adjusts. The adjustment is typically tied to changes in the prime rate, according to Citizens Bank. A small 0.25%, or 25-basis-point, change in either direction can amount to tens of thousands of dollars over time.
Credit Cards
Most credit card issuers base annual percentage rates on the prime rate, adding a certain percentage, called a margin, to it. As of May, the most current month for which the Fed has released data, the average rate for all credit card accounts is 20.68%. That’s an increase of 0.59%, or 59 basis points, over the first-quarter average of 20.09%.
If you have a $3,000 balance and make $35 minimum payments at the lower rate, it would take 103 months to pay off the card, and by the end, you’d have paid $3,312.78 in interest. Adding 59 basis points to the rate increases the total interest paid by $136.53.
Car Loans
Car loans are also based on the prime rate, according to Citizens Bank. The average rate for a 60-month loan was 7.48% at the beginning of the year. It since has risen 0.33%, or 33 basis points, to 7.81. Had you taken out a $20,000 car loan at the lower rate, your payment would have been $401 per month, and you’d have paid a total of $4,034.14 in interest by the time the car was paid off. Adding 33 basis points to the rate only increases your car payment by a few dollars, to $404, but it increases your total interest cost by $188.56, to $4,222.70.
How To Use Basis Points to Your Advantage
The best way to leverage basis points is to approach saving in a way that maximizes your yields, and approach borrowing in a way that minimizes your interest rates. Comparing rates from several banks or lenders is one way to do it. Another is to shore up your credit so that you qualify for those prime rates. A few basis points might not make a big impact on a small savings account, but across multiple accounts — especially long-term accounts like mortgage loans — you can save (or lose) thousands of dollars over time.
Information is accurate as of July 24, 2023.
This article originally appeared on GOBankingRates.com: What Are Basis Points and How Do They Affect Your Banking?
