A basis point is one-hundredth of a percentage point. That is, 100 basis points = 1 percent, theoretically of any measured quantity. It is most often used in financial calculations and especially in describing a change in interest rates, or a small difference between two rates of return (the spread). Basis points help provide precision when using measurements expressed as percentages.
Basis Points vs. Percentage Points
Percentage points, which break a whole in one hundred parts, can always be expressed in basis points. For example, 0.5 percent equals 50 basis points, 1.5 percent equals 150 basis points. Usually, however, basis points aren't used as mere substitutes for percentage points but for describing the difference between two percentage points: 0.5 percent is 100 basis points less than 1.5 percent or 4.55 percent is 5 basis points more than 4.5 percent, for example.
The main advantage of using basis points is that they are very clear in their meaning. If you said, for example, that a 4 percent interest rate "was down by 0.25 percent," that could either mean it dropped to 3.75 percent (4 - 0.25 = 3.75) or that it dropped to 3 percent, because 0.25 percent of 4 is 1, and 4 - 1 = 3. The statement wouldn't be clear. By using basis points, there is no such confusion. A drop of 25 basis points from a 4 percent interest rate can mean only one thing: the rate is now 3.75 percent.
It might not seem that something as small as a basis point, or 1 percent of 1 percent, is really necessary. But when dealing with large sums of money, a single basis point can be quite sizable. For example, each basis point on a $10 billion loan would be worth $1 million. Thus, when dealing with large amounts of debt, interest rates are often negotiated to the tenth or even hundredth of a basis point (1 percent of 1 percent of 1 percent) because the overall sums are so mind-bogglingly large.
Basis points are a convenient way to express "spread" so that it is easy to understand at a glance. Spread is used in a number of ways in the financial world; often referring to the difference between the buying and selling price of something, or the difference in return that two different investments produce. In either case, if the spread is expressed in basis points, it offers a quick and absolutely clear snapshot of the difference.
Pegged to Interest Rates
Loans whose interest rates are not fixed--those with floating interest rates--are often determined by adding X basis points to a certain financial benchmark. One of the most common benchmarks for lending is the London Interbank Offered Rate (LIBOR), which changes regularly. A borrower who takes a loan at 50 basis points + LIBOR is paying interest at the LIBOR rate, whatever it happens to be, plus an additional 50 basis points. Because basis points offer clarity and precision in calculating interest rates, the borrower will know the exact interest rate at any given time, even though the rate isn't fixed.
- Robert Kirk/Photodisc/Getty Images