Difference Between Discount Rate vs Interest Rate
Discount Rate is the interest rate that the Federal Reserve Bank charges to the depository institutions and to commercial banks on its overnight loans. It is set by the Federal Reserve Bank, not determined by the market rate of interest. An interest rate is an amount charged by a lender to a borrower for the use of assets. Interest rates are mostly calculated on an annual basis, which is also known as the annual percentage rate. The assets borrowed can be cash, large assets such as a piece of machinery, vehicles or building.
Discount Rate
In Finance, the discount rate can be defined as the following:
- The discount rate is used in the concept of the Time value of money- determining the present value of the future cash flows in the discounted cash flow analysis. It is more interesting for the investor’s perspective. The time value of money means a fixed amount of money has different values at a different point in time. Let’s take an example, which would be a better choice of getting Rs.100 today or getting Rs. 100 at the end of the year. The better choice would be getting Rs.100 today as you can earn a return if you invest it and you will be having the Rs.100 plus the return at the end of the year.
- The discount rate can also be referred to as the rate at which liabilities are discounted by the insurance and pension plan companies.
Interest Rate
Interest is the cost a borrower compensates to use someone else’s money.
For Example, Anand has taken a Loan amounting to Rs. 20,00,000 at a 6% annual rate of interest from a Bank. The bank didn’t give the requested loan amount. They are just lending you their money for a certain period of time (Assume 15 years). You have to pay the money back to the Bank, but not the whole amount at a time, you have to pay it year on year and also the 6 percent interest on the outstanding Loan balance for the privilege of using their money. Home loans, Car Loans, credit cards and Education loans all follow the same principle.
Buy a 10- Year bond or make a Fixed Deposit in the bank, and you’ll be getting the interest. However, someone will pay you interest for using your money. Interest rates are directly proportional to the risk profile of the borrower. The interest rate will be higher if the borrower’s profile is considered risky, the rate of interest charged on them will be on the higher side.
Head to Head Comparison Between Discount Rate vs Interest Rate (Infographics)
Below is the top 7 difference between Discount Rate vs Interest Rate:
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Key Differences Discount Rate vs Interest Rate
Both Discount Rate vs Interest Rate are popular choices in the market; let us discuss some of the major Difference Between Discount Rate vs Interest Rate:
- The interest rate is the amount charged by a lender to a borrower for the use of assets. The lenders here are the banks and the borrowers are the individuals. Whereas, Discount Rate is the interest rate that the Federal Reserve Banks charges to the depository institutions and to commercial banks on its overnight loans.
- Interest rates depend on a number of factors such as Borrower’s creditworthiness, a risk associated with lending. Whereas, the discount rate is calculated after taking into consideration the average rate that one bank would charge to other banks for taking the overnight loans.
- The discount rate can also be used in the concept of the Time value of money- determining the present value of the future cash flows in the discounted cash flow analysis. It is more interesting for the investor’s perspective. Whereas, Interest rates are calculated from the viewpoint of the Lenders.
- Interest rates are affected by Demand and supply in supply in the economy whereas, Discount rates are not affected by Demand and supply in supply in the economy.
- The lenders charge the Interest rate by the following two ways i.e., Simple Interest and Compound Interest. Whereas the calculation of the Discount rate is complex- Determining the present value of the future cash flows in the discounted cash flow analysis.
Head To Head Comparison Between Discount Rate vs Interest Rate
Below is the topmost comparisons between Discount Rate vs Interest Rate
| The basis of comparison | Interest Rate | Discount Rate |
| Meaning | An interest rate is an amount charged by a lender to a borrower for the use of assets. | Discount Rate is the interest rate that the Federal Reserve Banks charges to the depository institutions and to commercial banks on its overnight loans. |
| Charged on | Individuals/ Borrowers | Depository institutions/ Commercial banks |
| Rates are Decided by | Commercial banks | Central Banks |
| Dependency | Depend on a number of factors such as Borrower’s creditworthiness, the risk associated with lending and market rate of interest. | Not determined by the market rate of interest, is decided by the central banks. |
| Usage | Cannot be used in determining present value. | Can be used in determining the present value of the future cash flows. |
| Perspective | Based on the Market and focusing on the Lender’s point of View | Focusing on the Investor’s point of View |
| Economies | Affected by Demand and supply in supply in the economy. | Not Affected by Demand and supply in supply in the economy. |
Conclusion
After examining the above information, we can say that Discount Rate vs Interest Rate is two different concepts. A discount rate is a broader concept of Finance which is having multi-definitions and multi-usage. Whereas Interest rate has a narrow definition and usage, however, multi things are to consider before determining the interest rates. In some cases, you have to pay to borrow money then it is a direct financial cost. In other cases, when you invest money in an investment, and the invested money cannot be utilized in anything else, then there is an opportunity cost. Discount Rates vs Interest rates both are related to the cost of money but in a different way. If you have an interest in Finance and want to work in the Financial Sector in the future, then you should know the difference between Interest rates and Discount rates.
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