Understanding financial jargon can be a headache, especially if you run a small business. But there’s one term you can’t ignore: basis points (often abbreviated as BPS).
Whether it’s interest rates, loan agreements, or investment returns, basis points can have a significant impact on your bottom line.
In this article, we’ll give you all the information you need to know about what BPS are, why they’re important, and how you can use this knowledge to make informed financial decisions.
What are basis points?
A BPS is a unit of measurement used in finance to describe the percentage change in the value or price of a financial instrument. One BPS is equal to 0.01%. So when you hear that an interest rate has increased by 100 BPS, it means that the interest rate has increased by 1%.
This small unit is particularly useful when dealing with percentages less than 1%, where even small changes can have a significant impact.
For example, if a bank offers you a loan with an interest rate of 4.75% and the interest rate increases by 25 BPS, the new interest rate will be 5%. It’s a simple concept, but one that can be confusing if you’re unfamiliar with the terminology.
Another example could be exchange rates. Imagine you exchange £100,000 into euros and the exchange rate improves by 10 BPS.
Although this may seem insignificant, even a small improvement in the interest rate can give you noticeable savings on large amounts.
Why are basis points important?
Basis points are crucial in finance because they provide a clear and standardized way to discuss changes in interest rates and yields. In conversations where precision is important – such as negotiating loans or discussing investment returns – using basis points can reduce misunderstandings.
In fact, a small miscommunication about a seemingly insignificant percentage could result in significant financial discrepancies.
For small businesses, understanding the basics in the following areas is particularly important:
- Interest rates: Whether you’re borrowing money or earning interest on your savings, understanding how basis points work can help you understand how even a small change in interest rates can affect your finances. For example, if your business loan interest rate increases by just 50 basis points, the additional costs could amount to thousands of pounds over the life of the loan. On the other hand, a 25 basis point reduction in your savings account interest rate could mean a significant decrease in your expected return, especially if you rely on interest income to fund your business operations.
- Credit agreements: When you discuss the terms of a loan with a lender, the interest rate is often quoted in basis points. This allows for an accurate understanding of borrowing costs. For example, if your lender is offering a 15 basis point discount on a large loan, it’s really important to understand exactly how much money you’re saving. This knowledge can give you the confidence to negotiate better terms or compare offers from different lenders more effectively.
- Investment returns: Investors often use basis points to discuss the return on bonds and other fixed income investments. Knowing how to interpret these numbers will help you make smarter investment decisions. For example, if you compare two bonds — one with a yield of 3.75% and one with a yield of 3.65% — the difference of 10 basis points may seem negligible at first glance. However, over the life of the bond, this small difference could lead to a significant difference in returns, especially for larger investments.
BPS Importance in Finance
In finance, basis points are used to avoid confusion when discussing interest rates and percentages. When someone says “The interest rate went up 0.5%,” it may not be immediately clear whether they mean 0.5 percentage points (that would be 50 basis points) or a 0.5% increase in the original interest rate.
Using basis points allows financial professionals to be clear and concise.
For example, an increase from 4% to 4.5% is an increase of 50 basis points, not 0.5 basis points. Understanding this distinction is crucial when it comes to financial contracts or investments.
It’s easy to see how confusion can arise when terms like “half a percent” are used instead of basis points — especially in many financial discussions where clarity is crucial.
In the world of derivatives and complex financial instruments, just a few basis points can make the difference between profit and loss.
Traders and portfolio managers often make decisions based on tiny changes in interest rates. Therefore, it is important to understand the precise meaning of basis points in these contexts.
How to calculate basis points
Calculating basis points is straightforward once you get the hang of it. Here is a simple formula:
- 1 basis point = 0.01%
- 100 basis points = 1%
To calculate how many basis points a percentage represents, multiply the percentage by 100. Example:
- 0.25% = 25 basis points
- 1.5% = 150 basis points
If you want to convert basis points back to a percentage, divide by 100. So if you have 75 basis points, divide by 100 to get 0.75%.
Let’s consider a real scenario. You are a small business owner negotiating a £200,000 loan. The interest rate will be reduced by 30 basis points from 5.25% to 4.95%.
While 30 basis points may seem small, over the course of a 10-year loan this reduction could save you thousands of pounds in interest.
Common scenarios with basis points
Let’s look at a few more examples where understanding basis points can be particularly useful:
- Loan interest
Imagine you are negotiating a business loan and the lender offers an interest rate of 4.25%. After some discussion, they agreed on a 25 basis point cut. This means your new interest rate will be 4%, potentially saving you a significant amount in interest payments over the life of the loan. The exact amount saved depends on the size and term of the loan, but even a small reduction could improve your cash flow and free up funds for other business needs.
- Credit card rates
Credit card companies often increase interest rates in small increments, such as 50 or 100 basis points. Understanding this will help you make better decisions when choosing or managing a credit card. For example, if you’re thinking about transferring the balance to a card with a lower interest rate, knowing how to compare offers in basis points can help you avoid cards with hidden costs.
- Investment returns
If you are thinking about investing in a bond with a yield of 2.75% and learn that the yield has increased by 50 basis points, that means the new yield is 3.25%. Knowing this will help you decide whether the investment is right for you. Even a small increase in yield could significantly increase your returns over time, especially in a low interest rate environment.
- Currency exchange
For companies that work with international customers or suppliers, exchange rates can have a big impact on profitability. Suppose you exchange £500,000 into US dollars and the exchange rate improves by 20 basis points. Although 0.20% may not seem like much, it could mean a difference of several hundred pounds in your favour. Understanding how to monitor and take advantage of such changes can provide your business with a financial advantage.
- Interest rate hedging
If your business relies on loans or has large loans, you might consider hedging against interest rate increases. Understanding how hedging instruments like interest rate swaps work — often described in basis points — can help you manage your financial risks more effectively. For example, if market analysts predict a 75 basis point interest rate hike, you might decide to set a fixed rate now to protect your business from higher costs in the future.
Final thoughts
Basis points may seem like a small detail, but they play an important role in the world of finance. Understanding what basis points are and how they work will help you make more informed decisions about loans, investments, and other financial matters.
Remember that even small changes in interest rates or earnings can have a big impact on your business — so it pays to be precise.
Whether you’re negotiating a loan or evaluating an investment, understanding how basis points are calculated and interpreted will give you a clearer picture of your financial situation.
With this knowledge, you can make decisions that will benefit your business in the long term.
