What an Interest Rate Fundamentally Is

Money is something everyone needs but not everyone has enough of at the same time: some people have more than they need right now and would like to put it to use, while others need more than they currently have. Lending bridges that gap — but lending isn't free for the lender. Handing money to a borrower means the lender gives up using that money themselves for the loan period (an opportunity cost), and takes on the chance the borrower doesn't pay it all back.

An interest rate is the price that compensates the lender for both of those things, and — like any price — it's shaped by supply and demand: the pool of money available to lend (savers, banks) against the pool of people wanting to borrow it. When more people want to borrow than there is money available to lend, rates rise; when there's more money available to lend than people wanting to borrow it, rates fall.

A rate also has to account for inflation: if prices are expected to rise 3% over the year, a lender who only charged enough to break even in today's dollars would actually be repaid in dollars worth less than what they lent. So a real-world interest rate is roughly built from three pieces stacked together: enough to offset expected inflation, enough to compensate for giving up the money's use, and enough to compensate for the risk the borrower doesn't repay in full.

Roughly speaking, an interest rate can be thought of as three pieces added together:

interest rate ≈ expected inflation + a "real" return for waiting + a risk premium

• expected inflation— compensates the lender for prices rising while the loan is outstanding, so they're repaid in money worth roughly as much as what they lent
• a "real" return for waiting — compensates for giving up the use of the money itself, independent of inflation
• a risk premium— compensates for the chance the borrower doesn't repay in full, or repays late; riskier borrowers are charged more

This is why a government bond (a very low risk of not being repaid) usually carries a lower rate than a credit card (a much higher risk of default) even in the same economy at the same time — the inflation and waiting pieces are similar, but the risk piece is very different.

Say a friend asks to borrow $100 for a year. If you expect prices to rise 3% over that year, and you'd otherwise be fine just holding the cash, you might ask for 3% interest just to keep pace with inflation — $103 back.

But if this friend has missed payments before, you'd reasonably want more than $103, to compensate for the real chance you don't get fully repaid — say, 3% for inflation plus another 7% for the risk, or $110 back. A bank lending to a stranger with an excellent credit history would charge less than that, and a bank lending to a stranger with a poor credit history would charge more — the same idea, priced differently based on risk.