Discount interest definition

What is Discount Interest?

Discount interest refers to a loan where the interest on the loan is deducted from the loan up front. This means that the borrower only receives a loan that is net of the interest payment. Because the amount of the loan is reduced at the outset, the effective interest rate on the loan is higher than would normally be the case. This situation favors the lender, who does not have to lend out as much money, while also earning a higher effective interest rate on the arrangement.

Example of Discount Interest

As an example of discount interest, if a one-year $1,000 loan has $100 of interest expense associated with it, the borrower will only receive $900. In effect, the borrower has obtained a $900 loan and will then repay just the principal portion of the loan. $100 of interest on a $1,000 loan would appear to be 10%. However, since the interest percentage is calculated on the $900 amount loaned, the interest rate is actually 11.1%