Expert: Josh - 1/4/2007

Question
Hello:

I want to thank you for your quick reply and answer.
I am having some difficulty understanding the reasoning for this type of loan.

1. If I understand correctly, the borrower receives $282.00 and pays the banker $300.00 (face value)in one year. Although the banker deducted $18.00 as interest, the borrower pays the $282.00 plus $18.00. Is this where the borrower pays the interest from his own money?

2. Why would a bank offer this type of loan?  What is the benefit to the lender or borrower?

I thank you for your follow-up reply.

-------------------------------------------
The text above is a follow-up to ...

-----Question-----
Hello:

I recently read about a type of loan know as a bank discount loan in a business mathematics book.  I do not fully understand this type of loan. Perhaps you can explain. Here is an example:

When a bank discounts a loan, the banker takes the interest from the loan and gives the borrower the difference. For example, a $300.00 loan @ 6% interest for one year is $18.00. $18.00 from $300.00 is the amount the borrower will receive, $282.00.

When the borrower pays the loan he pays the banker $300.00.
Why doesn't he pay the $318.00, the loan or $300.00 and the interest of $18.00? He paid the interest with borrowed money. (?)

I thank you for any helpful explanation that you can provide.

-----Answer-----
> Don't pay $318 because borrower never received $318.
> The loan has a face value of $300 although the actual amount received is $300 less an interest of $18.
> Yes, the interest is initially deducted from the amount borrowed.

According to [1], this is the rate that banks charge on discount loans (loans with the interest deducted when the loan is made). The borrower receives the face value of the note, less the discount. A borrower taking out a $1,000 one-year loan pays the lender $50 in interest and receives $950 for use over the year. The rate of interest is 5.263% ($50/$950) in this example.

[1] "http://www.answers.com/topic/bank-discount-rate#after_ad1"

Answer
Hello,

Regarding Q1
Yes, I think you are right. Even though the borrower does not actually pay the $18 out of pocket, interest is effectively charged as a deduction on the loan during transaction.

Regarding Q2
I do not know enough to comment. One aspect, such as the compounding of interest is not demonstrated in this example. However, I think the one off deduction in this case may insure the borrower against potential fluctuation (future increase) in interest rate.