What is a discount loan? Definition and example
With a discount loan the lender calculates the interest and other related charges and discounts them from the face amount before lending to the borrower. However, the borrower has to pay back the whole amount – the principal, the related charges and the interest.
Interest is what the borrower has to pay on top of the principal when he or she takes out a loan.
Discount loans are typically issued for people who seek a short-term loan.
For the schedule of payments, the lender divides the total by the number of months the arrangement will last. However, in the vast majority of cases, the loan is paid back in one lump sum.
Many people will think the interest rate on this loan is 10% ($2,000 is 10% of $20,000), that is a mistake. You have to calculate what percentage $2,000 is of the principle ($18,000) – the answer is 11.11%.
Example of a discount loan
Imagine you wanted to borrow $20,000 and pay back twelve months later. The interest and charges came to $2,000.You would receive $18,000 from the lender. However, you would still have to pay back the whole $20,000.
Interest rates on discount loans tend to be higher than those on other types of loans.