What is an interest rate?

The concept of an interest rate is fundamental in finance, particularly concerning borrowing and lending. It represents the cost of borrowing money or the return earned on an investment expressed as a percentage of the principal amount. When someone borrows money, they are required to pay back not just the amount borrowed (the principal) but also an additional amount as compensation to the lender for the use of that money, which is the interest.

By defining the interest rate as a percentage paid to a lender for borrowed money, it highlights both the cost of taking a loan and the compensation for the lender’s opportunity cost—that is, the potential earnings they forgo by lending the money rather than using it for other investments. This definition is critical because it captures the nature of financial transactions involving loans, savings, and investments.

The other choices do not accurately represent what an interest rate is. For instance, describing it as an amount paid to a borrower confuses the roles involved in lending. Meanwhile, stating that it is a fixed amount earned on a deposit does not account for the variability and percentage nature of interest rates in different contexts. Lastly, claiming it is a universal rate applied to all loans ignores the fact that interest rates can vary widely based on factors like the borrower's