What is Discount Rate? - Definition, History & Formula

Instructor: Anthony Aparicio

Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology

When people or businesses expect to receive money in the future, there is a way to figure out how much that money is worth today. The percentage rate used to compute the value of future income is called the discount rate.

What is Discount Rate?

We all know that banks loan money to individuals but have you ever wondered what happens when a bank needs a loan? There are two main uses of the term discount rate that we will explore in this lesson. The first is when banks need to borrow money from the Federal Reserve and the other is when businesses want to figure out the value of future income.

Banks make a profit by collecting the interest on money loaned to individual and business customers. We know that banks can use a percentage of the deposits they hold from customer accounts but many times that may not be enough to supply all of the automobile, home, and business loans that they wish to make. When banks need to borrow money, they go to the Federal Reserve Bank and are charged a percentage of interest known as the discount rate.

There is also another definition of discount rate that is used in a process called discounted cash flow (DCF). As time passes, the value of money tends to decrease; therefore, the purchasing power of income at a time in the future is worth less right now. Today, we will work with Rita, a bank manager, and watch how she uses a discount rate in the course of her job.

History

Meet Rita, she is the manager at Richie Bank. Rita's family has been in the banking industry for a long time so she knows a lot about how banks work. She knows that banks use loans to leverage funds in order to make more profits. The more money that the bank is able to loan, the more they can make in interest payments from customers.

Rita knows that her best source of money is what she is allowed to use from the bank customer's savings accounts. However, it takes a lot of savings accounts to cover just a few new cars, trucks, boats, and houses that people purchase by borrowing money from the bank. When that money runs out and the bank wants to make more loans, Rita makes a call to the Federal Reserve Bank to borrow more.

The Federal Reserve Bank loans funds to commercial banks at a rate determined by the Board of Governors. There are actually different rates determined by the length of time that the money will be borrowed and the amount of risk taken. By changing the discount rate, the Board of Governors can change the amount of money available for loans, which affects the country's economy and inflation rate.

When discount rates are low, Rita can loan money to customers for a lower rate. However, if the bank has to pay 10% on the money they are borrowing, they will then have to charge customers a much higher rate on their loans. Most people will not agree to borrow money if the interest rates are too high.

Rita's great-grandmother started at Richie Bank back in 1920. Back then, prices were much different. A new car cost about $1,400, laborers were paid $5.50 to work a full 8-hour day, a newspaper was 2 cents, and a movie ticket was 17 cents! Obviously prices have changed a lot over the course of time.

Based on the change in the value of money, there has to be a way to compute what future income is worth now. For example, if Rita's great-grandmother was owed $1,500 in 1920 but would not be paid until 2015, that same $1,500 back then would not be able to purchase a new car now. As such, money that will not be paid until a time in the future (usually a lot less than 95 years) will have to be adjusted to see how much it is worth at that time.

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