Future Business Leaders of America (FBLA) Business Calculations Practice Test

How does the effective interest rate of a simple discount note compare to the stated discount rate?

1. Higher

2. The same as

3. Synonymous

4. Lower

The correct answer is: Higher

The effective interest rate of a simple discount note is typically higher than the stated discount rate. This relationship arises from the way interest is calculated on discount notes, where the interest is deducted upfront from the principal amount prior to the borrower receiving the funds. When the discount rate is applied, it reflects the percentage of the total note’s value that is subtracted to find what the borrower actually receives. However, the effective interest rate takes into account the time period over which the loan is repaid. Since the borrower receives less than the face value of the note but is obligated to repay the full face value at maturity, the cost of borrowing (represented as an effective interest rate) effectively increases. This distinction is important because while the stated discount rate might seem attractive, the actual cost of the borrowing is higher due to the way the interest is structured. Consequently, businesses and individuals should always consider the effective interest rate to understand the true cost of a discount note.