What does the interest rate on a loan represent?

The interest rate on a loan represents the charge for borrowing money. It is expressed as a percentage of the loan amount and reflects the cost to the borrower for using the lender's funds. When a borrower takes out a loan, they agree to pay back the principal amount plus interest over time. The interest charged compensates the lender for the risk of lending and the opportunity cost of not using those funds elsewhere.

Understanding the distinction is crucial; while it may seem that the total cost of the loan incorporates various factors such as interest, fees, and other charges, the interest rate specifically denotes the ongoing cost of the borrowed funds, which is calculated annually. It does not encompass the total repayment amount or the value of anything pledged as collateral, such as real estate in a mortgage.