Question

What does it mean to borrow money on a discount basis? This has to do with borrowing money from a bank on a discount basis. This is not related to bond issues/sales. (See chapter 7, page 238, "Interest Calculation Method").

Be cautious: borrowing on a discount basis has to do with going to a lender (banker) for a loan. Be sure not to confuse borrowing on a discount bases with the bond discount discussed later in chapter 7.

Answer 1

Borrow money on a discount basis means short-term lending arrangement in which interest amount for the entire loan period (plus other charges, if any) is deducted from the principal at the time a loan is disbursed. The borrower pays off the loan (the full principal amount) as arranged. Bank discount basis is a convention used by financial institutions when lending money. Taking into account the time value of money, the discount rate describes the interest percentage that an investment may yield over its lifetime. 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.

When a loan’s interest is discounted, the bank deducts the full amount of the interest that will be due on the
loan or note in advance, and the interest is withheld and not disbursed to the borrower. Having the interest
discounted and withheld results in a higher effective rate than simple interest because the borrower receives
less than the face value of the loan but has to repay the full amount of the loan, effectively paying interest on
the entire amount. In effect, discounted interest is similar to a compensating balance in that it reduces the
amount of funds that are received by and available to the borrower; therefore, raising the effective annual
rate of interest on the loan because the interest is paid on the full amount. The following formula can be used
only for loans with terms of exactly one year,

Effective Rate of
Discounted Interest = Interest on the Principal Amount of the Loan / ( principal – Interest “Withheld”)