What is a basis point?
Dan Nastou, CFA
The finance world is so littered with financy sounding terminology it’s easy to think industry professionals are deliberately trying to confuse outsiders.
But occasionally, a term that seems to be nothing more than gratuitous industry speak actually serves an important purpose. And “basis point” is a perfect example.
A basis point is a financial unit of measure that represents 1/100th of one percent. Or written in decimal form, one basis point = 0.0001 (since 0.01 is equal to 1%).
So 10 basis points = 0.1%, or one tenth of one percent.
And 100 basis points = 1%.
But why do we need basis points?
Sometimes shorthanded as bps, or “bips”, basis points are typically used for describing interest rates and bond prices. And there are actually two reasons why it’s useful terminology.
1. When you’re dealing with very large sums of money, even a fraction of a percent can add up to a lot of money. So it’s helpful to have a measurement that’s smaller than percentage.
2. When you’re talking about changes in interest rates, saying “percent” can get confusing.
For example, let’s say a business has a loan that currently charges 5%. But suppose another lender comes along and offers to reduce their interest rate by 1%. Does that mean their interest rate would go from 5% to 4%? Or does it mean it would drop to 4.95% (since 1% of 5% is 0.05%). It’s not particularly clear based on the ambiguity of “percent” in this case. But if the lender offered to reduce the rate by 100 basis points, it’s clear they are talking about reducing the rate to 4%.
This may seem like a minor clarification, but for financial institutions that are constantly quoting interest rates and bond prices day in, day out, it makes a big difference.
So next time you hear someone talking about basis points, you’ll know what they mean and why!
In the News You may occasionally hear about the Federal Reserve adjusting their target short-term interest rate. So if you hear “the Fed raised rates by 75 basis points”, that means they increased it by 0.75%. If the previous rate was 2.25%, that means the new rate will be 3%.
As always, this is education, not financial advice. Talk to your financial professional if you need help or are thinking about making changes to your investments.
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