Updated November 15, 2023
Difference Between Discount Rate vs Interest Rate
Discount Rate is the interest rate the Federal Reserve Bank charges to the depository institutions and commercial banks on its overnight loans. It is set by the Federal Reserve Bank, not determined by the market interest rate. An interest rate is an amount a lender charges 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 borrowed assets can be cash or large assets such as machinery, vehicles, or buildings.
Discount Rate
In Finance, one can define the discount rate as follows:
- It is more interesting for the investor’s perspective. 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. The time value of money means a fixed amount has different values at different times. For example, getting Rs.100 today or Rs would be better. 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 have 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 the insurance and pension plan companies discount liabilities.
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 interest rate from a Bank. The bank should have given the requested loan amount. They lend you their money for a certain period (Assume 15 years). You have to pay the money back to the Bank, but only part of the amount at a time; you have to pay it year after year and 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 get 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 interest rate charged on them will be higher.
Head To Head Comparison Between Discount Rate vs Interest Rate (Infographics)
Below is the top 7 difference between Discount Rate vs Interest Rate:
Key Differences Discount Rate vs Interest Rate
Both Discount Rates vs. Interest Rates are popular choices in the market; let us discuss some of the major differences between Discount Rates vs. Interest Rates:
- The interest rate is the amount a lender charges 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 charge to the depository institutions and commercial banks on its overnight loans.
- Interest rates depend on several factors, such as the Borrower’s creditworthiness, a risk associated with lending. The calculation of the discount rate involves considering the average rate at which one bank charges another bank for overnight loans.
- In the concept of the Time value of money, the discount rate plays a crucial role in determining the present value of 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.
- The economy’s demand and supply impact interest rates, but they do not influence discount rates.
- The lenders charge the Interest rate in the following two ways, i.e., Simple Interest and Compound Interest. Whereas the discount rate calculation 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 are the topmost comparisons between Discount Rate vs Interest Rate
| The Basis of Comparison | Interest Rate | Discount Rate |
| Meaning | Lenders charge borrowers an interest rate for using assets. | Discount Rate is the interest rate the Federal Reserve Banks charges to the depository institutions and commercial banks on its overnight loans. |
| Charged on | Individuals/ Borrowers | Depository institutions/ Commercial banks |
| Rates are Decided by | Commercial banks | Central Banks |
| Dependency | Depends on some factors, such as the Borrower’s creditworthiness, the risk associated with lending, and the market interest rate. | The central banks determine the discount rate, independent of the market rate of interest. |
| Usage | Determining present value is not possible with discount rates. | It can be used in determining the present value of 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, Discount Rate vs Interest Rate are two different concepts. A discount rate is a broader Finance concept with multi-definitions and multi-usage. Whereas Interest rate has a narrow definition and usage, many things are to consider before determining the interest rates. Discount Rates vs Interest rates are related to the cost of money but in different ways. Sometimes, you have to pay to borrow money; then, it is a direct financial cost. In other cases, when you invest money in an investment that cannot be utilized in anything else, there is an opportunity cost. If you are interested 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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