A discount rate is the percentage used to shrink a future dollar amount down to what it is worth in today's money. Push the rate higher and a future payment is worth less right now; pull it lower and that same payment is worth more.
How a discount rate works
Think of a discount rate as the return you could otherwise earn on your money starting today. If you could reasonably earn 5% a year, a payment of $1,050 due one year from now is only worth $1,000 to you today, because $1,000 growing at 5% becomes $1,050 in a year. That 5% figure is the discount rate doing the work. Raise the discount rate and the present value of a future payment falls; lower it and the present value rises. The effect compounds with time too, since a payment far in the future gets discounted more heavily than one arriving next year. A one percentage point change in the assumption can look small on paper, but it can move the present value of a payment due decades from now by a meaningful amount, which is why professionals who value pensions, legal settlements, or annuity income streams treat the number carefully rather than rounding it off.
What moves the discount rate
Discount rates generally track prevailing interest rates and bond yields, so they climb and fall along with the broader rate environment. That is part of why a lottery jackpot's lump-sum option shrinks as a share of the advertised prize when rates are high: the same lump of cash, invested at a higher rate, can still fund the same stream of payments. Insurers apply the identical logic in reverse when they price the guarantees behind an annuity, discounting the future income they owe back to a present cost, which is one of the forces behind the fixed annuity rates you see quoted at any given time. If you are ever offered a lump sum in place of a stream of future payments, whether from a lottery, a pension, or a structured settlement, it is worth asking what discount rate the buyer used to arrive at that number. A buyer applying a steeper discount rate than the market truly supports ends up keeping more of the difference for itself.
Frequently asked questions
What is a discount rate?
It is the percentage used to shrink a future dollar amount down to today's value. Push it higher and a future payment is worth less right now.
How does the discount rate affect present value?
Say you could earn 5 percent a year on your money. A hypothetical $1,050 arriving a year from now is only worth $1,000 today, because $1,000 growing at 5 percent for a year lands right at $1,050.
What causes discount rates to change?
It mostly tracks the interest rate and bond yield environment of the moment, so it climbs when rates climb and eases when they ease.
Written and reviewed by
James Forren Warren
Licensed Retirement Income Strategist · License #20551202
James Forren Warren is a licensed Retirement Income Strategist with Tax Free Wealth Plan. For the past five years he has helped individuals and families turn their savings into retirement income they can count on. He writes and reviews the annuity research on this site and keeps it plain: what a product does, what it costs you, and who it actually fits.
Educational only, not investment, tax or legal advice. Tax Free Wealth Plan LLC is a licensed insurance agency, not a registered investment adviser or broker-dealer. Annuities are not bank deposits, are not FDIC insured and are not guaranteed by any government agency. Guarantees are backed solely by the claims-paying ability of the issuing insurance company. Features, rates and availability vary by state and change over time; the contract and disclosure documents govern.