An interest rate is the percentage of a loan's principal a lender charges annually for the use of its money, before fees. It's the raw price of borrowing — distinct from APR, which layers in prepaid finance charges like origination fees.
The interest rate is the cost of borrowing money, expressed as a percentage of the outstanding principal, charged over a defined period (almost always annualized). A lender sets it in one of two ways: fixed, where the rate is locked for the life of the loan, or variable, where it moves with a benchmark rate — most commonly the prime rate or SOFR — plus a fixed spread the lender adds for its own margin and risk. Interest rate is not the same figure as APR. The interest rate reflects only the cost of the money itself; APR (Annual Percentage Rate) adds in prepaid finance charges — origination fees, points, and certain closing costs — amortized over the loan term, which is why APR on a given loan is always equal to or higher than its stated interest rate. Regulation Z under the Truth in Lending Act requires lenders to disclose both, so borrowers can see the raw rate alongside the true all-in cost. How a rate gets set: lenders start from a benchmark — the federal funds rate (which mechanically drives the prime rate) for most bank products, or SOFR for many commercial and variable-rate business loans — then add a spread based on the borrower's credit profile, collateral, and the lender's cost of funds. A borrower with strong credit and hard collateral gets a tighter spread; a subprime or unsecured borrower gets a wider one. This is why two businesses can see meaningfully different quoted rates from the same lender on the same day. Simple vs. compound: a simple interest rate applies only to the original principal each period. A compound rate applies to principal plus any interest already accrued, so the effective cost compounds over time — the gap between a loan's stated (nominal) rate and its compounded cost is what APY captures on the deposit side and what APR partially captures on the lending side.
The interest rate is the cost of borrowing the principal, full stop. APR adds prepaid finance charges — origination fees, points, certain closing costs — spread over the loan term, so APR is always equal to or higher than the interest rate. Compare loan offers by APR, not interest rate alone, since a lower-rate loan with a large origination fee can cost more than a higher-rate loan with none.
They start from a benchmark — typically the prime rate (itself set at roughly the federal funds rate plus 3 percentage points) or SOFR for many commercial products — then add a spread reflecting the borrower's credit profile, collateral, loan size, and the lender's own cost of funds. Stronger files get tighter spreads; weaker or unsecured files get wider ones.
A fixed rate locks in payment certainty for the full term — useful when rates are low or you want predictable budgeting. A variable rate typically starts lower but moves with its benchmark, so payments can rise (or fall) as the Fed changes the federal funds rate. Businesses with thin margins or short time horizons often prefer the certainty of fixed; borrowers betting on rate cuts sometimes choose variable.
Quoted rates are typically pegged to the benchmark rate (prime or SOFR) at the moment of quoting. If the Fed moves the federal funds rate between prequalification and closing, or if underwriting turns up new information about credit or collateral that changes your risk spread, the final locked rate can differ from the initial quote.