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What Is Discount Rate and Why Does It Matter? – Definition and Example


The discount rate is a financial term that can have two meanings. In banking, it is the interest rate the Federal Reserve charges banks for overnight loans. Despite its name, the discount rate is not reduced. In fact, it’s higher than market rates, since these loans are meant to be only backup sources of funding. During major financial crises, though, the Fed may lower the discount rate – and lengthen the loan time. In investing, the discount rate is the rate of return used to figure out what future cash flows are worth today. If you need help understanding this or any other financial concepts, consider working with a financial advisor.

What Is the Discount Rate at the Federal Reserve?

When the discount rate comes up in financial news, it usually refers to the Federal Reserve discount rate. This is the rate the Fed charges commercial banks for short-term loans of 24 hours or less. Sometimes, banks borrow money from the Fed to prevent liquidity issues or cover funding shortfalls. Those loans come from one of 12 regional Federal Reserve banks.

Banks use these loans sparingly since loans from other banks typically come with lower rates and less collateral. Meanwhile, asking the Fed for money may be seen as a sign of weakness, which banks want to avoid. (Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Fed must publicly disclose the names of banks that borrow from the discount window and the amount of the loan.)

Banks that borrow from the Fed fall into three discount programs, or “discount windows.”

  1. Primary credit, which makes overnight loans to banks that are in good financial shape.
  2. Secondary credit lends at an interest rate higher than the primary rate to banks that don’t qualify for primary credit.
  3. Seasonal credit, for banks with seasonal needs in places like farming or resort communities.

Who Sets the Discount Rate?

What Is Discount Rate and Why Does It Matter? - Definition and Example

The board of directors of each regional Federal Reserve Bank sets the interest rate for primary credit window loans every 14 days. The Board of Governors of the Federal Reserve System then approves the discount rate, which looks awfully similar in each region.

Since October 31, 2019, the primary rate has been 2.25%, and the secondary rate, which must be 50 basis points higher, has been 2.75%.  The seasonal rate is a floating rate based on market conditions and is the average of the federal funds rate and the rate of three-month certificates of deposit (CDs).

Why the Discount Rate Is Important

The discount rate helps steer the Fed’s monetary policy. At the beginning of the last recession, the Fed lowered the discount rate to help stressed financial institutions cover costs. In those situations, short-term loans tend to get a bit longer. At the height of the financial crisis in 2008, loans with a discount rate were as long as 90 days.

Discounted Rate of Return for Investments

The second way that a discount rate is used is when cash flow is discounted when analyzing a financial investment. The discounted cash flow (DCF) rises when a particular investment costs more money to buy or ends up generating less of a financial return than expected or more than the cost is valued at. In other words, the DCF analysis helps you decide whether an investment is worth the money it will cost you upfront by analyzing the current cost by the value of future revenue.

Taking into account the time value of money, the discount rate describes the interest percentage that an investment may yield over its lifetime.  For example, an investor expects a $1,000 investment to produce a 10% return in a year. In that case, the discount rate for valuing this investment or comparing it to others is 10%.

The discount rate allows investors and others to consider risk in an investment and set a benchmark for future investments. The discount rate is what corporate executives call a “hurdle rate,” which can help determine if a business investment will yield profits.

Businesses considering investments will use the cost of borrowing today to figure out the discount rate. For example, $200 invested against a 15% interest rate will grow to $230. Working backward, $230 of future value discounted by 15% is worth $200 today. This is helpful if you want to invest today but need a certain amount later.

Discount Rate Limits

What Is Discount Rate and Why Does It Matter? - Definition and Example

The discount rate is often a precise figure, but it is still an estimate. It often involves making assumptions about future developments without taking into account all of the variables. For many investments, the discount rate is just an educated guess.

While some investments have predictable returns, future capital costs and returns from other investments vary. That makes comparing those investments to a discount rate even harder. Often, the best the discounted rate of return can do is tilt the odds slightly in favor of investors and businesses.

Bottom Line

The Fed’s discount rate comes up in the news usually during financial crises. It’s the rate the Fed charges banks for overnight loans and doesn’t directly impact individuals. The business sense of the term, though, is relevant to investors. It’s one way of assessing an investment’s value by analyzing whether an investment is worth the initial cost to the investor.

Tips For Investing

  • Investing isn’t easy and it can take time to figure out how to properly invest to meet your financial goals. If this sounds like you, then you may want to speak to a financial advisor who can help answer questions and set you on a path for your financial situation. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Still want to try your hand at stock picking? You can cut down costs by making your trades through an online brokerage account. Brokers such as Charles Schwab, E*Trade and TD Ameritrade offer zero-commission online trades.

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