Whether you're familiar with financial jargon or have never heard of the term "basis point," it's important to understand the fundamentals of basis points because they can affect your monthly mortgage payments. You may also be interested in how they function in the context of interest rate changes when purchasing a home.

What Is A Basis Point?

Basis points are a financial instrument used by portfolio managers and investors to indicate the percentage change in interest rates or financial ratios in US Treasury bonds, mutual funds, exchange-traded funds, and real estate-based investments.

Professionals use mathematical terms to describe basis points, but you can understand them even if you're not a financial analyst or banker.

How Much Is A Basis Point?

Basis points, also known as bps (pronounced "bips"), are a unit of measurement used to describe changes in interest rates in a financial instrument. One basis point is equivalent to 0.01 percent, or 0.0001. One percent is equal to one hundred basis points.

How Do Basis Points Work In Mortgages?

Depending on the type of mortgage you have, changes in basis points can have an impact on your monthly mortgage payments.

When interest rates rise, so does your monthly mortgage payment. The percentage you pay to borrow money from a lender for a set period of time is referred to as your interest rate.

If your mortgage rate is variable, as is the case with adjustable-rate mortgages (ARMs), your interest rate may fluctuate based on market rates.

ARM payments may increase on adjustment dates, and basis point increases will affect your principal (the amount you owe) and interest rate. Assume you have an ARM with an interest rate of 3.5 percent, and the interest rate changes to 3.75 percent at a later date. This means that your interest rate has increased by 25 basis points.

When looking for a home, it's a good idea to lock in your interest rate. If you do not, you may have to pay basis point increases in the form of a higher interest rate.

How Do Basis Point Hikes Affect a Mortgage?

1. Basis Point Hikes: Because mortgage payments are made up of a combination of interest and principal, when the interest rate rises, so does the payment. A $450,000 mortgage at 4.1 percent, for example, has a monthly payment of $2,174.39. A single basis point increase, to 4.11 percent, raises the payment to $2,177 and raises the total cost of the loan by $939.60 over the course of 360 payments. A 40-basis-point increase to 4.5 percent raises the payment to $2,280.08, or more than $100 per month.


2. Broader Impacts: Increases in interest rates do more than just increase your payment. They may actually prevent you from being approved for the loan. While lenders make loans based on the value of the property, they qualify you for loans based on your ability to repay. Many of them use the loan payment as a percentage of your annual income to calculate this. If an increase in interest rates means that your yearly mortgage payments will exceed 28 percent of your salary, they may refuse to approve the loan.


3. Discount Points: If the interest rate on your loan rises too high, you can buy a lower rate by paying discount points. Discount points are a type of prepaid interest in which you pay the bank a fee up front in exchange for the bank lowering the interest rate. The amount you can save on your loan's interest rate will vary depending on how many points you pay and how your bank underwrites it, but paying one point, or one percent of the loan's balance, will reduce the rate by 25 basis points.


4. Commercial Mortgages: Interest rates on commercial mortgages work similarly to those on residential loans, so a basis point increase will result in a higher payment. However, when the bank underwrites your loan, the income ratio is calculated differently. Instead of looking at your income, it looks at the income of the property. If the interest rate rises to the point where the property no longer meets its debt service coverage ratio, the loan will be denied or limited in size.

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