When it comes to finance and savings products, even the smallest changes in interest rates can make a difference in returns. One way these changes are measured is through something called basis points. This article broadly covers what basis points are, how they’re used in setting interest rates, and why even small shifts in basis points can impact the interest rate offered on term deposits.
What are basis points?
A basis point is a unit of measurement in finance equal to one one-hundredth (1/100th) of one per cent (i.e. 0.01%), used to express changes in interest or yield.
For example, if the interest rate on a term deposit moves from 2.00% to 2.25%, that’s an increase of 25 basis points.
It’s a shorthand way of expressing small changes that can have a noticeable impact on money and securities markets.
Why use basis points?
In finance, precision is essential, and even small shifts in interest rates can affect earnings, especially on larger sums of money. Basis points are used to assist with calculations.
For example, instead of saying a rate increased by 0.10%, financial experts will say it increased by 10 basis points.
This may make it easier to compare and understand changes, especially when you’re dealing with fractions of a percentage point.
How to calculate basis points
Converting between basis points and percentages is simple once you know the math. To convert basis points to percentages, simply divide the number of basis points by 100.
For example
- 50 basis points = 0.50%
- 10 basis points = 0.10%
If an interest rate moves from 1.50% to 1.75%, that’s an increase of 25 basis points (or 0.25%).
The Reserve Bank of Australia and basis points
The Reserve Bank of Australia (RBA) plays a key role in setting the broader economic environment for interest rates. When the RBA adjusts the official cash rate, they typically do so in increments of 25 basis points (or 0.25%). These changes then spread through the financial system, affecting everything from mortgage rates to term deposit rates.
How the cash rate affects term deposits
While changes in the cash rate set by the RBA can influence term deposit rates, other factors also play a role. These include market expectations, funding requirements of the authorised deposit-taking institutions (ADIs) that offer term deposits and other savings products, and broader economic conditions. For example, if the RBA cuts the cash rate by 25 basis points, some ADIs may lower term deposit rates, but the exact adjustment will depend on these additional factors. Similarly, when the RBA raises rates, term deposit rates may increase, but not always to the same extent.
How basis point changes affect term deposit interest earnings
Once you’ve locked in a term deposit, the applicable interest rate that you’ve agreed should stay the same for the entire term length, no matter what happens with basis points or interest rates in the broader market, provided you hold to maturity. This means you’re protected from any downside changes – your rate won’t go up or down, and your returns are fixed.
However, when your term ends and if you’re looking to reinvest your money in a new term deposit, any changes in the economic and financial factors described above may affect the rates offered at that time. This is something to be mindful of when your term deposit ends and you’re potentially looking into rolling over your money into a new term deposit.
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