What’s a basis point?

“Teachable moment” is a buzzword these days. So I’ll sprinkle some nutritional content into my column today lest you accuse me of piling on just more empty calories during the holiday season. And thus I introduce the term “basis point.” It’s an easy concept, and it’s a mystery to me why it isn’t taught in junior high school to promote some basic level of financial literacy. It’s an essential term if you borrow money, lend money, invest, speculate, or just want to know what the heck is going on in the world.

Incidentally, the topic comes as a suggestion from a Chinese business owner. We were swapping tutelage in Mandarin for help in business English. The term “basis point” came up, and my counterpart requested that I write about it. So this column is part of my “language exchange” obligation.

I’ll start with a dry definition, but if you don’t like my definition, don’t run away, since I’m going to backfill it step-by-step. But we’ll get the defining out of the way by stating that a basis point equals one-hundredth of a percentage point.

Yeah, I see you giving me that look. The look that says, “huh?” Or, maybe, “why should I care?”

But I’ll disarm you with my roguish charm, flashing straight teeth and a cocked smile, and I’ll keep explaining it.

Here’s the deal: “Percent” is a loaded term. And it’s more invasive than crab grass: The entire world is built on contracts and agreements and analysis and terminology that involve percentages.

Here’s how percentages can lead us astray: Let’s say you’re reading in the news that a tax rate is being increased from 10 percent of income to 12 percent of income. The reporter refers to it as a “2-percent” tax increase, since 12 minus 10 is, indeed, two. But the increase in tax payments in this example isn’t 2 percent, it’s actually 20 percent!

It’s easy to illustrate with numbers: If you pay a 10 percent tax on $100 of income, your tax is $10. If the tax rate goes up to 12 percent, then you’ll pay $12 instead of $10. So you’re paying $2 more under the new way than the old way. The increase, $2, is fully a 20-percent increase over the old payment of $10. Just divide $2 by $10, and there’s your answer; 0.2, or 20 percent.

Anyway, how would we express the increased rate from 10 percent to 12 percent? Well, I would say it is an “increase of 200 basis points.” That’s nice and clean. It gets around a lot of semantic pitfalls. That’s why the pros use it.

I’ve used big, fat, round numbers thus far, but basis points are more typically used for little, tiny, exact numbers. For example, let’s say you are shopping for a mortgage. The loan officer offers you a loan at a 5.0 percent interest rate if you sign the papers on Monday, but if you wait until Tuesday, the rate will go up by 15 basis points. And that’s the way he will probably say it, “15 basis points.”

What he’s saying is that the loan rate is going up from 5.0 percent to 5.15 percent. It’s easy to eyeball where those basis points landed. There’s no trickery here, it’s as simple as it looks.

Let’s say you call again on Wednesday to check rates. He tells you that the rate just fell by 2 basis points. What’s the new rate? Well, we take the 5.15 percent rate from Tuesday, and subtract 2 basis points, which puts us at a 5.13 percent rate. Then let’s say on Thursday the rate goes up by 1 basis point; this will put us at 5.14 percent.

Hey, is that all there is to the basis point gig? Yep.

Why does this matter so much? Because the pros who deal with this stuff usually don’t have an endless amount of time to go around and around in circles chasing misconceptions about percentages. You’ll have an easier time “talking turkey” with them if you know what a basis point is.

Furthermore, next year is going to be one heck of a humdinger on the economic front, and if you want to follow the serious press you’ll note the term “basis point” is used all the time.

I’ve seen a lot of problems, some of them quite expensive, that could have been avoided by a basic understanding of basis points.