Discount Rate

The discount rate is different from a more normal interest rate. The two are separate concepts in financial mathematics. The discount rate is based on the future cash flow in lieu of the present value of the cash flow. The divisor, for the discount rate, is the resulting future value, including the income. The divisor in the calculation of interest is the original investment.

Assume I have $80, and I buy a government bond that pays me $100 in a year’s time. The discount rate represents the discount on the future cash flow:

The interest rate on the cash flow is calculated using 80 as its base:

It should become apparent that for every interest rate, there is a corresponding discount rate, given by the following formula:

Another way to think of a discount rate is to consider that the discount rate tells you how much of your future value is interest and how much is principal. For example, if you deposit $100 into an account that pays 50% interest, the amount that you will subsequently withdraw will be $150. Your discount rate is 0.5/(1+0.5) = 1/3 or 33.3%. Based on this, you can say that 33.3% of your $150 is interest and the other 66.7% is principal.