The Loan Discount Rate refers to an interest rate which commercial banks and various other financial institutions pay on loans they take from the discount window of their regional branch of the Federal Reserve Bank. It can also pertain to the discounted cash flow or DCF analysis interest rate. This rate would set the current value of all future cash flows.
Where the DCF analysis is concerned, the discount rate considers more than simply the time value of money. It also factors in the insecure future cash flows. The higher a future uncertainty risk may be for the uncertain cash flows, the higher the discount rate will prove to be. There is also a third meaning to the discount rate term. This is the rate which insurance companies and pension plans utilize to discount their liabilities. In general, the first definition above is the primary one for this phrase, and the one we will mostly consider in greater detail throughout this article.
The Federal Reserve is the government institution tasked with setting and administering the primary interest rates which the Federal Reserve banks set. It is not the market that sets these rates. The Fed offers these loans via its discount window as a lender of last resort to its member financial institutions when they are in trouble. This window became extremely popular back in the end of 2007 and 2008 when the national economic and financial situation in the U.S. declined dramatically almost overnight.
The Federal Reserve then engaged in necessary emergency steps in order to deliver significant liquidity to the struggling financial system. That year, the borrowing from the discount window made a new all-time record high of $111 during this crisis peak of the Global Financial Crisis and Great Recession of October in 2008. The Board of Governors of the Federal Reserve System then slashed the loan discount rate to a low of .5 percent not seen since the end of the Second World War on the date of December 16th of 2008.
It is always instructive to consider a real world concrete example of a challenging concept such as this one. If an individual anticipates that he will receive a thousand dollars in a certain year, he may need to ascertain how much the present value of said thousand dollars is right now. To determine this, he would have to choose a given interest rate at which to discount the present value. If the individual employed a ten percent rate, then the money a year from now would be worth $909.09 today. This is $1,000 divided by 110%. If the anticipated receipt date of the thousand dollars was for two years in the future, then the present value of the money would today be $826.45.
Companies often need to figure out an appropriate discount rate to deploy on a given project. A great number of firms utilize the WACC Weighted Average Cost of Capital when the risk profile of the project proves to be similar to the company profile as a whole. In scenarios where the risk profile of the project is significantly different from the company’s operations in general, they will instead utilize the CAPH Capital Asset Pricing Model. This delivers a project-specific discount rate which might more appropriately reflect the risk of the given project.
The loan discount rate should never be confused with discount points. These are a kind of prepaid fees in lieu of interest which mortgage borrowers are able to buy at their closing. They reduce the amount of the interest dollars which the borrowers will have to pay out in later re-payments. Such points typically cost a percent of the entire loan amount. Every point reduces the interest on the loan by from an eighth to a quarter of a percentage point.