A basis point, which is also commonly known as “bps” or “bips,” is a unit of measurement that represents a percentage change of value or rates within various financing instruments. It is a term commonly used throughout the finance industry and can have varying impacts based on the financing type it’s associated with.
How Basis Points Work
Basis points are applicable to a wide variety of instances in finance, including interest rates, bond yields, equity securities, and currency exchange rates. They act as a unit of measurement that can be used to calculate and compare yields, costs, and differences in interest rates.
Essentially, they are equal to 1/100th of 1% and are used to notate changes in percentages. They can be both positive and negative and are mainly used when determining the cost of lending, or changes in investment yields.
Generally, when basis points increase, so do payments. The opposite can be said with a decrease, in which payments would be lower.
When it comes to small business financing, it will most commonly be used to assign an interest rate, with a benchmark index rate along with the lender’s basis point margin to determine total financing costs.
Basis Points in Interest Rates
You’ll often see basis points come up when outlining terms for a financing agreement. In terms of business financing, small business loan requirements and qualifications can impact the assigned basis points set by a lender and the rate structure of your financing agreement, especially if you have a variable interest rate. You may also see this reflected in the rate of return on checking and savings accounts.
Basis Points in Investments and Yields
While basis points are commonly associated with interest rates, they can also be applicable to yields and are indicative of change or differences in the value of assets and investments. Examples of this can include treasury bonds, corporate bonds, and equity securities.
How Are Basis Points Calculated?
When calculating basis points, you’re essentially converting the number of basis points into a percentage. Usually, this is added with a benchmark rate index to determine the cost of financing or is applicable to determine the rate of change of other financial instruments.
That said, you can also convert a percentage into basis points. You can determine either with the following calculations:
- Basis points to percentage: Divide total basis points by 100
- e.g., 200 bps ÷ 100 = 2%
- Percentage to basis points: Multiple the percentage by 100
- e.g., 2% × 100 = 200 bps
Example of How Basis Points Are Used
In an example specific to business financing, let’s consider a scenario where a borrower is looking to get a small business loan. They work with the lender to determine business needs and loan terms.
When determining the interest rate, the lender will assign a basis point margin in addition to the benchmark rate index utilized. Together, these will play a part in determining the borrower’s required repayments.
In this case, let’s say the lender uses the Prime Rate as the benchmark rate index and assigns a 200 bps margin for the interest rate. That would be represented as follows:
Prime Rate (8.00%) + 200 bps (2.00% percentage rate) = 10% interest rate
Additionally, if the loan had a variable interest rate and the Prime Rate rose from 8.00% to 8.50%, this example would demonstrate that the rate increased by 50 basis points. Similarly, if rates were to drop to 7.00% from 8.00%, a decrease of 100 basis points is what would be reflected.
How Basis Points Impact Financial Decisions
The consideration of basis points is important in that it can impact various financial decisions. Whether it be to determine a margin and assign an interest rate or calculate the change in investment yields, they can be used to evaluate any potential risks before making important decisions.
Why Basis Points Are Important
They can play an important role in evaluating and comparing changes in rates and yields. They allow for insight into economic trends and help manage personal and business finances. They’re useful representations for identifying changes and making adjustments as needed within various financial instruments.
Frequently Asked Questions (FAQs)
Can basis points be negative?
Yes—and they can be both positive and negative. When basis points are negative, they indicate a percentage reduction and can impact various forms of financing based on the terms of the agreement.
What is the difference between basis points and percentage points?
Generally, basis points and percentage points go hand in hand. For example, basis points are 1/100th of 1%, and calculations can be reverted from each value.
Can basis points be used in personal finance?
Yes. Basis points are commonly used in many forms of financing and can be utilized in instances such as getting a personal loan or making other personal financial investments.
Bottom Line
Basis points are a common term that you’ll likely come across if you’re seeking financing. Depending on your financing needs or investments, basis points can be used to measure trends or changes and may be influenced by a variety of other factors. Be sure to read financing agreements carefully and communicate with your provider or adviser if you have any questions regarding basis points.
