An interest rate is the amount of interest due per period, in proportion to the amount lent, deposited, or borrowed (called the principal sum ). The total interest on an amount loaned or borrowed depends on the principal sum, the interest rate, the frequency of compounding and the duration for which it is lent, deposited or borrowed.

The annual interest rate is the rate over a period of one year. Other interest rates apply over different time periods, such as a month or a day, but are usually annualized .

The interest rate has been characterized as “an index of the preference…for a dollar of present [income] over a dollar of future income”.  The borrower wants or needs to have money as soon as possible and is willing to pay a fee – the interest rate – for this privilege.

Influencing factors 

Interest rates vary according to:

• government directives to the central bank to achieve government objectives
• the currency of the principal lent or borrowed
• the time to maturity of the investment
• the borrower’s perceived probability of default
• market supply and demand
• the amount of the guarantee
• special features such as call layouts
• mandatory reserves
• compensating balance

as well as other factors.

Example 

A business borrows capital from a bank to purchase assets for its business. In return, the bank charges interest on the company. (The lender may also require duties on the new assets as collateral .)

A bank will use the capital deposited by individuals to grant loans to their customers. In return, the bank should remunerate the individuals who have deposited their interest in the capital. The amount of interest payment depends on the interest rate and the amount of capital they have deposited.