What Are Basis Points and How Do They Affect Your Mortgage?

What Are Basis Points and How Do They Affect Your Mortgage? article image.

When you're taking out a mortgage to buy a home, particularly if you're a first-time homebuyer, you may come across all sorts of unfamiliar terminology. One of these terms may be "basis points." Basis points represent changes in interest rates, and they are a common feature of mortgages that have the potential to increase or decrease the cost of your loan. Follow along to learn more about this important element of mortgages.

What Are Basis Points (BPS)?

A single basis point equals 1/100th of 1 percentage point. Therefore, 100 basis points (also known as BPS, or "bips") would add up to 1%.

Why is this math important? Depending on the type of mortgage, a change in basis points could affect the amount of your monthly payment as well as the total interest you'll pay on your loan. So, if the interest rate on your mortgage rises by 100 basis points—from 4% to 5%, for example—your monthly mortgage payment could rise as well. However, if the rate drops by 100 basis points—from 4% to 3%, for instance—your monthly mortgage payment could drop in turn.

How Do Basis Points Work?

It's important to pay attention to basis points whether you have an adjustable-rate mortgage (ARM) or a fixed-rate mortgage, which keeps the rate at the same percentage for the life of the loan (such as 4.25% for 30 years).

The interest rate for an ARM periodically changes when a financial index tied to your mortgage also changes. When your loan's interest rate climbs, your monthly mortgage payment typically increases; if the rate falls, your monthly mortgage payment typically decreases.

The interest rate for an ARM normally is locked in for a set period, such as five years. But after that period ends, the interest rate could go up at certain intervals, such as every 12 months. This could cause the principal and interest for your mortgage to grow, resulting in larger monthly payments.

Let's take a look at a couple of scenarios where it might be important to know about basis points.

Basis Points and Fixed-Rate Mortgages

First, let's consider basis points for a fixed-rate mortgage.

A mortgage lender tells you they can offer a 30-year, fixed-rate mortgage for $300,000 at an interest rate of 4%. But your lender then finds out they can lower the interest rate by 50 basis points to 3.5%.

In this example, the monthly payment for the mortgage with the 4% rate would be $1,432.25. Over the life of the loan, you'd pay a total of $515,608, including $215,608 in interest.

But if you're able to get the same loan at 3.5%, the monthly payment would be $1,347.13. That's $85.12 less per month than the 4% loan. More importantly, the total amount paid over the life of the loan would be $484,968 roughly $30,000 less than the 4% loan. That reflects a drop in interest paid from $215,608 for the 4% loan to $184,968 for the 3.5% loan.

Basis Points and ARMs

Now, let's turn to basis points and ARMs.

Let's say you've got a 30-year ARM for $300,000 with an initial interest rate of 3%. Your initial monthly payment would work out to $1,264.81. But at the end of five years (60 months), the fixed rate then becomes an adjustable rate. If the interest rate adjusts upward every 12 months at 25 basis points, or 0.25%, and the rate is capped at 12%, the monthly payment could climb up to $1,804.70. That's nearly $600 higher than the initial monthly payment.

In this scenario, the total payments over 30 years would be $560,460, including $260,460 in interest.

Basis Points vs. Discount Points

When you're getting a mortgage, you may hear about "basis points" and "discount points." These points aren't the same, though.

As explained, a basis point represents 1/100th of a percentage point. Therefore, 100 basis points equal 1%. By contrast, one discount point equals 1% of the loan amount. For example, one point on a $200,000 mortgage would work out to $2,000. When you take out a mortgage, you can buy discount points to reduce the interest rate over the life of the loan. This can lead to lower monthly payments and lowered interest costs in the long term.

So, let's say you pay $2,000 for one discount point on a $200,000 loan. If you started with an interest rate of 4.5%, buying a single point generally brings the interest rate down to 4.25%. In this case, the monthly mortgage payment would dip from $1,013.37 to $983.88.

The Bottom Line

Regardless of the basis points or the type of loan, you should check your free Experian credit report and free Experian credit score before you shop for a mortgage. Being armed with this information may give you an edge in terms of getting the lowest interest rate possible.

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