Business Development

What is bps in finance? Everything you need to know

Business Advice | 12 August 2021 | 3 years ago

What is bps in finance

Bps is a common abbreviation in finance for the term “basis points”, which are a smaller unit of measure for percentages. A basis point is equal to 1/100th of one percentage point, so 10 basis points are the same as 0.1%. This might seem like an insignificant amount, but even 1 bps can make a huge difference in large sums. It’s important to understand how this conversion works, because many investments are measured in terms of bps instead of percentage. 

In this article, we will explain what basis points are, how they are used, and why they are so important in finance and investments.  We will also explain where the term basis point comes from, and why people use it instead of percentages.

Mortgage rate bps

What are basis points?

Basis points are the unit used to measure interest rates on loans, bonds and other financial products. They represent one-hundredth of a percentage point (.01%). The term is derived from the Latin word basis meaning “support” or “foundation.” A change in 100 basis points equals a change of 1% – which can also be written as +/-1%. For example, an increase in 200 bps would equal to +2%, whereas a decrease in 500 bps would equal -5%.

What is calculated in bps?

The main use for basis point calculations is in finance and economics when people want to measure small changes over time.  For example, a change of one basis point in the cost-of-living index would be equivalent to an increase or decrease in inflation of 0.01%. 

Another common use for bps is as part of the yield on a bond that pays periodic interest payments. For example, a £10,000 bond paying annual interest at 100 bps will pay £100 per year; while if it paid 200 bps, then it would pay £200 per year (a 50% higher rate).

Bps are also used to describe the changing interest rates of a home mortgage. This is because mortgages rates will often change less than 1%. You can fry your brain thinking about mortgage repayments increasing 0.35%, whereas using 35 bps is easier to compute.

Why do people use bps instead of percentages?

As can be seen with the mortgage example, people often use bps because % calculations can quickly get confusing with smaller numbers. After all, what does 0.02% look like? Most of us think of percentages as being 0 to 100, so when we start getting into decimal points, it seems to defy the whole purpose of using percentages. Bps is more mentally digestible, and can even enable us to do seemingly difficult calculations in our heads.

When are percentages and bps used at the same time?

When percentages and bps are used together, it is often to clarify an ambiguous change in circumstances.

For instance, if you had a savings account that paid 5% interest per year, and it then underwent a 5% boost, what does this mean?

Does it mean that you now receive 10% interest? (your original 5% + 5% boost)

Or does it mean that you now receive 5.25%? (your original 5% + 5% of 5)

In order to clear up the confusion, if we say that the account pays 5% interest and has received a 500bps increase, you know that you will now receive 10%.

What is the equation for converting bps into % and vice versa?

This equation is actually very simple once you are comfortable with the relationship between bps and %.

To convert % to bps, you just multiply by 100.

For example:

1% = 100bps

1.5% = 150bps

100% = 10,000bps.

To go the other way and convert bps into %, you just need to divide by 100.

Investment rate bps

Where does the term basis point come from?

The term “basis point” first emerged in the 1870s to describe a unit of measure used in engineering drawings. It derives from the Latin word “basis”, meaning “support” or “foundation.” It wasn’t until 1964 that bps were adopted as an alternative method for quoting percentages by Irving Fisher, one of the most notable American economists and statisticians.

Today, basis points are typically quoted in relation to percentage but can also be quoted as decimal values where each decimal value is equal to 0.01%. For example, if the yield-to-maturity is 12%, then it would be equivalent to 120 basis points.

What is the importance of basis points for investments?

Basis points are important to keep in mind when you read about investment returns and yields as they often measure small changes over time that can add up to a significant change over a long period of time.  The same goes with currency exchange rates as it’s always useful to know whether the rate has changed by 100bps or 0.01%.

How can you secure favourable mortgage and loan rates?

The following steps will help you find the best possible mortgage or loan:

  • Determine your credit score by requesting it from one of the three major credit reporting agencies; these scores range on a scale from 300 to 850, with 750 being considered an excellent grade.
  • Search online for available rate quotes in order to compare them side-by-side in order to see which have lower interest rates. Some websites provide consumers with pre-qualified mortgages while others do not (you want this feature if at all possible.)
  • Find out how long the mortgage or loan will be in effect for and what other fees are associated, such as a processing fee (which is often an upfront cost that can range from several hundred pounds to upwards of one thousand).
  • Request additional quotes–this should always be done with at least three different lenders where rates vary by more than 25bps.

In summary

When you understand what bps are used for, it is easy to see how they can help make sense of finances. Bps and % work together to give a more accurate picture of what’s happening with interest rates and other financial matters that fluctuate in small amounts over time. Knowing how to compare these two numbers will help you to be better prepared for future decisions involving money or investments. If you are ever unsure about any numbers or percentages on a loan, mortgage or investment, do not sign anything until you have sought further advice.

 

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