Interest Rate Vs. Discount Rate

office details image by .shock from <a href='http://www.fotolia.com'>Fotolia.com</a>

A discount rate sounds like someone's saving money, but that's not true. The Federal Reserve uses "discount rate" to describe the interest it charges on special short-term loans. The difference between discount rate and interest rate is that the discount rate is higher.

TL;DR (Too Long; Didn't Read)

The discount rate is a special interest rate the government charges when banks borrow money from the Federal Reserve. As an example, in late 2019 the regular interest rate for banks borrowing money was 1.5% to 1.75%, while a federal primary credit overnight loan costed 2.25%.

Defining Interest Rates

An interest rate is the cost of borrowing money. If you take out a business loan, your bank makes its money on the transaction by charging interest. When you deposit money in an interest-bearing account, the reverse happens: The bank pays you for giving it access to your money.

Banks lend each other money too. They have to because they're required to keep a minimum level of reserve funds on hand. If one bank's reserves get too low, it looks to other banks to help.

While commercial lending rates vary between banks, bank-to-bank loan interest rates are set by the Federal Reserve. The interest rate on the loan is known as the federal funds rate.

The Role of the Reserve

The government created the Federal Reserve as a central bank that could keep the monetary system both flexible and stable. Established in 1913, the Fed has duties that include regulating banks to keep the banking system stable and influencing money and credit conditions.

The Federal Reserve doesn't set interest rates on business loans, mortgages or consumer credit. It does, however, set the interest rate for federal funds. As that affects the cost to banks of maintaining their reserve, a higher federal funds rate can prompt banks to raise interest on loans they make.

The Fed also loans banks money when normal bank-to-bank loans aren't enough. A bank may have trouble finding money because a lot of customers have made large withdrawals. It can also result from a crisis, such as the chaos after 9/11.

Discount Rate vs. Federal Funds Rate

When banks borrow from each other, they do so at the federal funds rate. The Federal Reserve prefers banks to loan money to each other, rather than look to the government for help. That's why the difference between the discount rate and interest rate exists — so that banks turn to the Fed only as the lender of last resort.

The Fed refers to discount-rate loans as borrowing via the "discount window". Banks have three options: primary credit, secondary credit and seasonal credit, with most loans falling into the primary-credit window. Loans under any of the three programs must be fully secured by collateral.

  • The Fed reserves primary credit loans for banks in sound financial condition that need a short-term cash infusion. The typical primary credit loan is an overnight one.  When the Fed refers to the discount rate, primary credit is what they're talking about. The rate is higher than the federal funds rate.

  • Banks that don't qualify for primary credit can turn to the secondary credit program to shore up their cash reserves. The secondary credit discount rate is higher than for primary credit.

  • Seasonal credit is for small banks that have recurring fluctuations in funding. Banks in agricultural or seasonal resort communities are typical candidates. The discount rate is an average of selected market interest rates.

Current Rates: An Example

So what's the difference between the primary credit discount rate and the interest rate for fed funds loans? As of late 2019, the fed funds rate is 1.5% to 1.75%; primary credit loans are 2.25%.

If a bank needs secondary credit, the discount rate is 2.75%. Seasonal banks get a better deal: A 1.7% discount rate puts them at the high end of the fed funds range.

References

About the Author

Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com

Photo Credits