The discount method definition
/What is the Discount Method?
The discount method can refer to two possible applications, both involving lending activities. One application is to reduce the amount paid for a bond to increase the associated interest rate for the investor , while the other application involves the issuance of a reduced loan amount to offset the initial deduction of interest payable . In more detail, these two applications of the discount method are noted below.
The Discount Method for Bonds
The discount method refers to the sale of a bond at a discount to its face value , so that an investor can realize a greater effective interest rate . For example, a $1,000 bond that is redeemable in one year has a coupon interest rate of 5%, but the market interest rate is 7%. Therefore, an investor will only agree to buy the bond, with its $50 annual interest payment, at a price of $714.29 (calculated as $50 divided by 7%). Thus, $714.29 x 7% = $50.
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The Discount Method for Debt
The discount method refers to the issuance of a loan to a borrower , with the eventual amount of interest payable already deducted from the payment. For example, a borrower may agree to borrow $10,000 of funds under the discount method at a 5% interest rate for one year, which means that the lender pays only $9,500 to the borrower. The borrower is obligated to pay back the full $10,000 at the end of the year. This approach yields a higher effective interest rate to the lender, since the interest payment is calculated based on a higher amount than was paid to the lender. In the example, the effective interest rate was 5.3% (calculated as $500 interest, divided by $9,500 paid to the borrower).
The first interpretation of the term is the more common usage of the discount method.
