Basis Points Explained
Not long after your mortgage process begins you will come across the term “basis point.” Real estate jargon can be confusing, so we want to clarify this as much as possible and explain why it’s important.
Basis points are the common way to measure percentages in finance, especially equity indices and interest rates, and loans are often quoted with basis points as the unit. These units can be referred to in abbreviations like “bps” (pronounced “bips”) or “bp.” The term “basis” comes from the base change between two interest rates or other percentages. One basis point equals 0.0001, or 0.01%.
An interest rate that has increased by 1% would equal 100 basis points difference, and if that rate increases again by 25 basis points the new rate would be 1.25%. If the quote on your mortgage rate was 4.5% last week and it rose by 10 basis points then this week is would be 4.6%.
Why are BPS important?
Basis points remove any confusion around statements like “The Federal Reserve increased interest rates by 1% from 10%.” This could be interpreted two different ways. Are they saying the new rate is 10.1% or 11%? Using basis points instead clears up any confusion. By saying the rate increased by 100 basis points confirms that the rate went from 10% to 11%.
Why is the unit so small?
These fractions of percentages might seem small and insignificant to note, but with a loan as large as a mortgage, every dollar counts. For example, lenders usually give quotes on mortgage rates by .125% increments called “eighths”, making each eighth 12.5 basis points. If you get a quote for a $300,000 mortgage loan, an eighth increment (either up or down) can increase or decrease your monthly interest by $31 each time.
Basis points are also useful when comparing annual percentage rates (APR). APR tells you what the rate would be if all the closing costs were included and spread out over the lifetime of the loan. APR disclosures list costs line by line and include three decimal places in order to be as accurate as possible. Units this specific also make it easy to compare rates between different lenders. Once you know the basis point unit of measurement it’s easier to see the differences in APR quotes. The difference between one rate at 4.031% and 4.011% will be very similar, while comparing 4.031% and 4.161% will reveal one with significantly higher closing costs listed in the line items.
Here’s one more table with basis points in eighths for quick reference:
|2 eighths (1 quarter)||0.25%||25|
|4 eighths (1 half)||0.5%||50|
|6 eighths (3 quarters)||.75%||75|
|8 eighths (or 1)||1%||100|