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, the two applications of the discount method are as follows:
- Bonds. The discount method refer 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.
- Debt. The discount method can refer 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.