Discount rate
The rate used to convert future money into today’s value; also the rate the Federal Reserve charges banks for short-term loans.
What it means
In time-value-of-money math, the discount rate is the rate used to shrink future cash flows down to present value. It reflects what the money could otherwise earn plus a cushion for risk and inflation. A higher discount rate makes future payments worth less today.
The term has a second, unrelated meaning in banking: the interest rate the Federal Reserve charges banks that borrow directly from its discount window. That rate is set by the Fed and is generally above the federal funds target. Context usually makes clear which meaning is intended.
Example
Suppose someone promises you $1,000 in one year. Using a 5% discount rate, its present value is $1,000 ÷ 1.05, or about $952. At a 10% discount rate, it would be worth only about $909.
How it’s used
- Valuing pensions, settlements and lump-sum offers
- Comparing investments with cash flows at different times
- Reading news about Federal Reserve policy
Related terms
Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.