What does “Basis Point” mean?

In the realm of mortgage lending and investing, the term “Basis Point” is a crucial concept to understand. It is a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form. In the context of interest rates, if a rate increases from 2.00% to 2.01%, it has risen by one basis point.

The term “Basis Point” is commonly used in the finance industry, especially in the context of mortgages and investments. It is used to denote changes in interest rates, yields, and equity indexes, and is a critical measure in the pricing of financial assets. Understanding the concept of basis points can help investors and borrowers better comprehend the intricacies of financial markets and make more informed decisions.

Origins of the Basis Point

The term “Basis Point” has its roots in the financial markets of the United States, where it was first used in the early 20th century. The term was coined to provide a clear, standardized way of expressing small changes in interest rates or yields, which could be confusing when expressed in percentage terms. The use of basis points helped to eliminate this confusion and provided a more precise way of expressing these changes.

Over time, the use of the term has spread globally and is now a standard part of financial jargon in countries around the world, including Australia. It has become an integral part of the language of finance, used by investors, brokers, and lenders alike to communicate about changes in interest rates and the pricing of financial assets.

Why Basis Points are Important

Basis points are important in the financial world for several reasons. Firstly, they provide a standardised way of expressing changes in financial quantities, which can be particularly useful when dealing with small changes. For example, saying that an interest rate has increased by 50 basis points is clearer and more concise than saying it has increased by 0.50%.

Secondly, basis points are used in the calculation of financial quantities. For example, the yield on a bond is often quoted in basis points, as is the cost of credit default swaps. By using basis points, these quantities can be expressed in a way that is easy to understand and compare.

Application of Basis Points

The application of basis points is widespread in the financial industry. They are used in a variety of contexts, from the pricing of financial assets to the calculation of interest rates and yields. Here, we will explore some of the key areas where basis points are used.

One of the most common uses of basis points is in the context of interest rates. When a central bank, such as the Reserve Bank of Australia, changes its key interest rate, it is often reported in terms of basis points. For example, if the bank increases its rate from 1.50% to 1.75%, this would be described as a rise of 25 basis points.

In Mortgage Lending

In the context of mortgage lending, basis points are used to express changes in mortgage rates. A change of one basis point in a mortgage rate can have a significant impact on the total amount of interest paid over the life of a mortgage. Therefore, understanding basis points can help borrowers to better understand the potential cost of a mortgage and to compare different mortgage offers.

For example, if a mortgage lender offers a rate of 3.50% and another offers a rate of 3.45%, the difference is 5 basis points. While this might seem small, over the life of a 30-year mortgage, it could amount to a significant sum.

In Investing

In the world of investing, basis points are used to express changes in the value of investments, such as stocks, bonds, and mutual funds. They are also used to express the cost of investment products, such as the expense ratio of a mutual fund, which is often quoted in basis points.

For example, if a mutual fund has an expense ratio of 0.75%, this would be equivalent to 75 basis points. If the expense ratio were to increase to 0.80%, this would be a rise of 5 basis points.

Understanding Basis Points

Understanding basis points requires a basic knowledge of percentages and decimal places. As mentioned earlier, one basis point is equivalent to 0.01% or 0.0001 in decimal form. Therefore, 100 basis points make up 1%, 200 basis points make up 2%, and so on.

When dealing with interest rates or other financial quantities, a change of one basis point means that the rate or quantity has changed by 0.01%. For example, if a bond yield increases from 2.00% to 2.01%, it has increased by one basis point. If it increases from 2.00% to 2.10%, it has increased by 10 basis points.

Calculating Changes in Basis Points

To calculate a change in basis points, you need to know the initial and final values of the rate or quantity you are dealing with. The change in basis points is then calculated as the difference between the final and initial values, multiplied by 10,000 (since one basis point is 1/100th of a percent).

For example, if a mortgage rate increases from 3.50% to 3.75%, the change in basis points would be (3.75 – 3.50) * 10,000 = 25 basis points. This calculation can be used to determine changes in basis points for any financial quantity.

Conclusion

In conclusion, the term “Basis Point” is a fundamental concept in the world of finance, particularly in the fields of mortgage lending and investing. It provides a standardised way of expressing changes in financial quantities, making it easier for investors, borrowers, and financial professionals to communicate and understand these changes.

Whether you’re an investor looking to understand changes in the value of your investments, or a borrower seeking to understand the cost of a mortgage, having a solid understanding of basis points can be extremely beneficial. By understanding this concept, you can make more informed financial decisions and better navigate the world of finance.

Ready to Move Forward with Your Mortgage?

Now that you’re equipped with the knowledge of what a basis point is and its significance in finance, take the next step towards your property goals with Funding. As your dedicated property finance partner, we’re here to accelerate your journey with innovative solutions and expert support. Don’t let complexities hold you back. Get your quote today and move forward faster with Funding.

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