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.