What Is a Basis Point? Definition and Examples
Nov 10, 2023
Blueprint Income Team
A basis point is a standardized unit of measurement that's used extensively in finance to represent small fluctuations in interest rates, bond yields, and other financial percentages. Specifically, one basis point corresponds to one hundredth of a percentage point, or 0.01%. This means that a change of one basis point indicates an increase or decrease of 0.01% in the applicable rate or yield.
For instance, consider a loan with an interest rate that rises from 4.25% to 4.26%. In this example, the interest rate has increased by one basis point. Similarly, if the yield on a bond drops from 4.25% to 4.00%, it has decreased by 25 basis points. This standardized unit of measurement allows financial professionals to communicate and compare changes in interest rates and other financial variables with precision and accuracy.
Table of Contents
- How do annuity providers use basis points?
- Where does the term "basis point" come from?
- Managing risk
- How do you calculate basis points?
- Transparency and clarity
- Real-world examples of basis points
- Interest rate adjustments
- Why use basis points instead of percentages?
- Investment performance
- Why are basis points used?
- Illustrations and projections
How do annuity providers use basis points?
Annuity providers often communicate annuity rate changes through basis points. Providers use basis points to establish the pricing and interest rate assumptions for their annuity products. The interest rates set by the annuity provider directly impact the income payments that you receive.
These interest rates are typically based on prevailing market rates, adjusted by a certain number of basis points. The use of basis points allows annuity providers to set competitive rates while accounting for their desired profit margins and risk factors. There are a few key areas in which annuity providers use basis points:
Basis points help annuity companies in evaluating investment performance and determining risk. By analyzing market movements and asset allocation within investment portfolios, they can make informed decisions about where to allocate funds to maximize returns while minimizing potential risks.
Transparency and clarity
Basis points offer transparency and clarity when communicating fees and charges to annuity holders. Communicating in percentages can be confusing; if you are currently being charged a 20% fee and your annuity provider says they are increasing that fee by 10%, will they be increasing the fee by 10% of the 20% (22%), or by 10% altogether (30%)?
Basis points work to clear this confusion. If you are being charged a 20% fee and your provider increases it by 200 basis points, you can rest assured knowing the new fee will be 22%.
Interest rate adjustments
Annuity contracts often include provisions for interest rate adjustments. These adjustments are usually tied to changes in a specific reference rate, such as a government bond yield or a market index.
The changes in the reference rate are typically expressed in basis points. When the reference rate changes, the annuity provider will adjust the interest rate applied to the annuity accordingly, which affects the income payments you will receive.
Annuity providers invest your premiums to generate returns and ensure the sustainability of the annuity payments. They often measure and communicate the performance of these investments in basis points.
For example, if the investment portfolio of the annuity provider generates a return of 150 basis points above a specific benchmark, it indicates that the investments have outperformed the benchmark by 1.5%. This performance measurement assists annuity providers in evaluating the effectiveness of their investment strategies and monitoring the financial health of their annuity portfolios.
Illustrations and projections
When marketing annuity products, providers often show illustrations and projections to potential customers. These projections typically include assumptions about interest rates, investment returns, and fees.
The use of basis points allows annuity providers to present these assumptions in a standardized manner. For example, an annuity illustration may assume an interest rate increase of 100 basis points in the second year to demonstrate the potential growth in your income payments.
Where does the term "basis point" come from?
The financial sector has used this term for decades. The word "basis" derives from the base move between two percentages. The word "point" means that the term is a unit of measurement. As financial markets evolved, so did their more precise measurement units.
Financial professionals needed a common unit to discuss and analyze changes in interest rates, bond yields, spreads, and other financial variables accurately. By adopting basis points, professionals could communicate changes more precisely and facilitate clearer comparisons and discussions.
How do you calculate basis points?
Calculating a basis point is simple. One basis point is equal to one hundredth of a percentage point, or 0.01%. To calculate a basis point, follow these short steps:
- Start with the percentage you want to convert into basis points. For example, let's say you have an interest rate of 3.75%.
- Multiply your interest rate by 100, so 3.75 x 100 = 375.
- 3.75% becomes 375 basis points.
In this example, an interest rate of 3.75% is equivalent to 375 basis points. An easier way to remember this is to move the decimal point on the percentage to the right two places. So, you would move the decimal point in 3.75% two places to the right to get 375 basis points.
If you would like to convert basis points to a percentage, follow these steps:
- Start with the number of basis points you want to convert. Let's say you want to convert 250 basis points.
- Divide your basis points by 100, so 250 ÷ 100 = 2.5.
- Add a percentage symbol and your 250 basis points becomes 2.5%.
The formula shows us that 250 basis points are equivalent to 2.5%. Alternatively, you can simply move the decimal to convert basis points into a percentage. For example, if you move the decimal in 250 to the left two places, you get 2.5%.
Real-world examples of basis points
Basis points are widely used across the world of finance, from annuity providers to federal banks. Here are some real-world examples of how you can use basis points:
- Central bank monetary policy: Central banks, such as the United States Federal Reserve or the European Central Bank, use basis points to communicate changes in interest rates as part of their monetary policy decisions. When a central bank adjusts interest rates, they often do so in increments of 25 basis points, or 0.25%. These changes have far-reaching effects on borrowing costs, investments, and the overall economy.
- Mortgage rates: Changes in mortgage rates are commonly expressed in basis points. Lenders adjust mortgage rates in response to shifts in market conditions and interest rate trends. For example, if mortgage rates increase by 50 basis points, it means they have gone up by 0.5%, affecting monthly mortgage payments and affordability for borrowers.
- Bond yields: The bond market uses basis points extensively to express changes in bond yields. A bond's yield represents the return you can expect based on its current price. When bond yields fluctuate due to market conditions, credit risk, or changes in interest rates, the variations are often communicated in basis points. For instance, if a bond yield increases by 75 basis points, this indicates a rise of 0.75% in the yield, impacting the bond's pricing and attractiveness to investors.
- Interest rate spreads: Basis points are crucial when analyzing interest rate spreads, which measure the difference between two interest rates. For instance, the spread between corporate bond yields and government bond yields of similar maturities is often expressed in basis points. Changes in these spreads, such as an increase or decrease of 20 basis points, indicate a widening or narrowing of the yield difference, affecting investment decisions and risk assessments.
Why use basis points instead of percentages?
Basis points are used instead of percentages in financial contexts for a few important reasons:
- Precision: Basis points provide a higher level of precision when discussing small changes in interest rates, bond yields, and other financial percentages. Since one basis point is equivalent to one hundredth of a percentage point (0.01%), it allows for more accurate measurement and communication of even the slightest fluctuations. This precision is particularly important in financial markets where small changes can have significant impacts.
- Standardization: Basis points offer a standardized unit of measurement that the financial industry universally understands. By using basis points, financial professionals can ensure clear and consistent communication when discussing changes in interest rates or spreads. This common unit helps to avoid confusion and facilitates effective comparisons and analysis across different financial instruments and markets.
- Avoiding misinterpretation: In some cases, using percentages alone can lead to misinterpretation or confusion. For example, saying an interest rate increased by 5% without specifying whether it refers to 5 percentage points or 5% of the initial rate can cause ambiguity. Using basis points eliminates this confusion, as the unit explicitly conveys a specific increment of 0.01%.
Why are basis points used?
Using basis points in finance provides a standardized, precise, and easily comparable unit of measurement. It enhances clarity, reduces ambiguity, and enables more effective communication, analysis, and decision-making in financial markets, where even small changes can have significant implications. Understanding how basis points work can help you make more informed financial choices as you invest for retirement.
Blueprint Income Team
We are a team of finance, insurance, and actuarial professionals working to make it easier for everyone to achieve a steady and comfortable retirement. We write about annuities (the good and the bad) and provide strategies to help Americans prepare for retirement.