What are basis points and how are they used?

If you’ve been following the news about inflation over the past two years, chances are you’ve heard the term “basis points.” It’s a term that’s typically used in the financial industry, so it remains nebulous to many consumers. But because the basis point is used to denote a change in interest rates — whether it’s rate changes for savings accounts or credit cards — it’s important to understand the concept behind this numeric notation.

In this article, we’ll break down the basics of basis points, how to calculate them into percentages and what they mean for you in the context of Federal Reserve rate hikes.

What is a basis point?

A basis point is primarily used to denote changes in interest rates. Common abbreviations of the term include “bps,” “bp” and “bips.” One basis point is equivalent to one one-hundredth of one percent. In other words, 50 basis points equals 0.50 percent, and 100 basis points equals 1 percent.

How do you calculate a basis point?

To convert basis points into percentages, divide the basis point figure by 100. So, if you’re talking about 250 basis points, you can divide 250 by 100 to get 2.50 percent.

Conversely, to convert percentages into basis points, you must multiply the percentage by 100. So, if you want to convert 5% to basis points, multiplying by 100 will give you 500 basis points.

How are basis points used in banking?

Basis points are used primarily to denote changes in interest rates. Using basis points rather than percentages allows for more precise communication about the difference between two interest rates.

For example, if a current interest rate is at 10 percent, and it’s expected to rise by 5 percent next month, someone could interpret that to mean that the new rate will be 10.5 percent (calculating 5 percent of 10 percent, which is then added to the original rate and converted back into a percentage). But, if you’re using basis points in this example, a 500-basis-point rise next month clearly means that the new interest rate next month will be 15 percent.

In banking, basis points may be used to communicate the change in your annual percentage yield (APY), which is used to denote how much you earn on your deposit accounts such as certificates of deposit or savings accounts.

It can also tell you the change in your annual percentage rate (APR), which is used to denote the yearly rate on loan products such as credit cards or mortgages.

The Federal Reserve (the U.S. central banking system) often uses basis points to indicate its increase or decrease in the federal funds rate, which is the interest rate at which banks can borrow and lend from each other, usually on an overnight basis. In July, the federal reserve raised the federal funds rate by 25 basis points, meaning it raised the rate by 0.25 of a percentage point.

Raising the federal funds rate is the Fed’s primary tool to combat inflation because it raises interest rates on lending products, including mortgages and auto loans, for consumers.

This means that when the federal funds rate increases, the cost of borrowing (or, the amount of interest on any given loan) also increases. Conversely, when the federal funds rate decreases, the cost of borrowing typically also decreases.

Bottom line

The basis point is a metric that’s typically used to indicate the change in interest rates, and it’s the primary way the Federal Reserve communicates its rate hikes. But understanding basis points can be useful beyond just Fed announcements, as you may be informed of interest rate changes on your deposit accounts with this metric.

When in doubt, some simple math can help convert basis points into percentages, and vice versa. Divide basis points by 100 to convert them into percentages, or multiply a percentage by 100 to get the basis point equivalent.