What is Discount Contract? Definition of Discount Contract, Discount Contract Meaning and Concept
The discount contract is the agreement by which a creditor assigns his right to collection on a debt with future maturity. In return, your counterpart - a financial institution - makes you a payment today.
In a discount contract, at the end of the financing term, the bank , as the new owner of the loan, may collect it from the debtor.
Participants in the discount contract
The participants of the discount contract are the following:
- Discounting: Bank or financial entity that pays the loan in advance.
- Assignor or discounted: Creditor who assigns the loan in exchange for liquidity.
Main characteristics of the discount contract
The main characteristics of the discount contract are the following:
- The bank discounts the interest that would be generated from the payment of the advance until the maturity of the debt. Thus, the amount received by the transferor is less than the principal of the loan. The above will be better explained with an example later.
- In addition to interest, the financial institution also discounts commissions and other expenses.
- If the debtor does not pay the debtor, for any reason beyond the control of the debtor, the bank may demand re-entry by the debtor. The latter as long as a debt has been transferred. This is known as the "except good end" clause. Said condition marks a difference with respect to the assignment of credits where the joint and several liability of the creditor may or may not exist.
- The discount can be made on bills of exchange, promissory notes, ordinary credits or even stock coupons. The latter are titles that certify the right to collect dividends and that can be negotiated.
- The credits assigned cannot have expired or be in dispute.
- The discounter can approach another financial entity to assign their collection rights. This, in exchange for a consideration in the present. This operation is known as a rediscount.
Types of discount contracts
The types of discount contracts, depending on their nature, are as follows:
- Commercial: When the discounted document exists as a consequence of a commercial operation. This is the case, for example, of a bill of exchange that is accepted in a sale on credit.
- Financial: If the discounted document does not have any transaction behind it, but has been issued exclusively to obtain financing from the bank.
Discount contract example
Suppose that a company needs liquidity in the short term for an unforeseen expense. It also has an account receivable with a maturity of three months of US $ 10,000.
The company approaches the bank and the bank offers a discount contract at an equivalent annual rate of 5%. In addition, a 1% commission will be applied for the operation.
First, we calculate the quarterly interest rate (i)
i = [(1 + 0.05) ^ (1/4)] - 1 = 0.0123
So, the interest discount is applied:
10,000 / (1 + 0.0123) = 9,878.77
Finally, we consider the 1% commission to obtain what the transferor will receive:
9,878.77 * (0.99) = US $ 9,779.98
The transferor will receive $ 9,779.98. Actually, the value of your account receivable is $ 10,000, but when you receive it earlier, you give up a small part.