Discount Rate vs Interest Rate
Interest rates and discount rates are rates that apply to borrowers and savers who pay or receive interest for savings or loans. Interest rates are determined by the market interest rate and other factors that need to be considered, especially, when lending funds. Discount rates refer to two different things. While discount rates are the rates that are charged by banks for loans provided for overnight funding, they are also the rates that are used to discount future cash flows to the present value. The article that follows clearly explains both these terms, and shows the similarities and differences between the two.
Interest Rate
Interest rates are the rates that are applied when saving or borrowing funds in a bank or financial institution. Interest rates are usually expressed as yearly rates. Interest rates are regulated by country’s central bank depending on the levels of demand and supply for money in a country’s economy. Since the country’s central bank controls the economy’s money supply, they have the necessary power to regulate the interest rates. This is done by controlling the interest rate that is applied to banks that borrow funds from the central bank. The interest rates that are applied to various loans will also depend on a number of factors such as the creditworthiness of the borrower, the risk of lending, etc. If the central bank wants to reduce the money circulation (money supply) high interest rates will be set to encourage saving and if the central bank wants to increase spending and investment the interest rates will be set low.
Discount Rate
Discount rates may refer to two different things; the interest that is charged by the central bank from banks and financial institutions that borrow funds and the interest rates that are used in discounting cash flows. In the first situation, the discount rate is the rate that the central bank charges depository institutions on loans that are provided on an overnight basis. This rate is set by the country’s central bank and is not decided by merely demand and supply. However, this rate will take into consideration the average rate that banks would charge other banks to take overnight loans from one another. There are different types of loans that depository institutions obtain from the central bank, and each type of loan will have its own discount rate. On the other hand, the discount rates are also used to determine the present value of future cash flows of a business. Discount rates are used to discount cash flows because of the time value of money.
What is the difference between Discount Rate and Interest Rate?
Discount rates and interest rates are both rates that are paid and received for borrowing or saving money. There are 2 meanings to the word discount rate, and it may either refer to the rate that is used by firms to calculate the present values of future cash flows, or the rate that is charged by the central banks for overnight loans taken out by depository institutions. Interest rates, on the other hand, refer to the rates that bank charge when loans are provided and the rates that are paid to individuals who deposit and maintain savings. Interest rates are determined by the forces of demand and supply and are regulated by the central bank. Deposit rates (overnight fund rates) are determined by the central bank by taking a number of factors into consideration.
Summary:
Discount Rate vs Interest Rate
• Interest rates are the rates that are applied when saving in or borrowing from a bank or financial institution.
• Discount rates may refer to two different things; the interest that is charged by the central bank from banks and financial institutions that borrow overnight loans and the interest rates that are used in discounting cash flows.
• Interest rates are determined by the forces of demand and supply and are regulated by the central bank. Deposit rates (overnight fund rates) are determined by the central bank by taking a number of factors into consideration.