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What is the discount rate and why does it matter?

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 and accounting, the discount rate is the rate of return used to figure what future cash flows are worth today.

Federal Reserve Discount Rate

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, which 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?

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 point 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).

Importance of Discount Rate

What is the discount rate and why does it matter?

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 the discount rate were as long as 90 days.

Discounted Rate of Return

The discounted rate of return – also called the discount rate – is the expected rate of return for an investment. Also known as the cost of capital or required rate of return, it estimates current value of an investment or business based on its expected future cash flow.

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 other 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 backwards, $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 the discount rate and why does it matter?

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 affect individuals. The business sense of the term, though, is relevant to investors. It’s one way of assessing an investment’s value.

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Photo credit: ©iStock.com/Xesai, ©iStock.com/manfeiyang, ©iStock.com/ juststock

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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