What Is an Interest Rate?

What Is an Interest Rate?

An interest rate is the cost of borrowing money, expressed as a percentage of the outstanding principal per year. On an amortizing loan, interest is recalculated each period on the remaining balance, so the amount of interest paid decreases as the balance is paid down.

How Interest Rates Are Set

Lenders set interest rates based on the risk-free rate (linked to U.S. Treasury yields or the federal funds rate), a credit risk premium based on the borrower's creditworthiness, and market competition. The Federal Reserve's federal funds rate influences short-term rates. Mortgage rates are more closely tied to the 10-year Treasury yield.

Fixed vs. Variable Interest Rates

A fixed interest rate stays the same for the entire loan term. A variable (or adjustable) interest rate changes periodically based on an index such as SOFR plus a margin set by the lender. Variable rates may start lower than fixed rates but introduce payment uncertainty over time.

What a Rate Difference Actually Costs

Simple interest: a $10,000 personal loan at 8% for 1 year costs $800. On a $250,000, 30-year mortgage, 6% costs $1,498.88/mo ($289,595 total interest) versus 7% at $1,663.26/mo ($348,772 total interest) -- a 1-point difference is $164/mo and about $59,200 more interest over 30 years.

Interest Rate vs. APR

The interest rate reflects only the cost of the principal. APR reflects the total cost of the loan including fees, expressed as an annual percentage. When comparing loan offers, use APR for a more complete cost comparison.

Common Interest Rate Mistakes

Comparing offers by advertised rate alone. Compare APR, which includes fees, not just the headline rate.

Assuming a Fed rate cut drops your mortgage rate immediately. Mortgage rates track the 10-year Treasury more closely than the Fed funds rate.