An interest rate is the cost of borrowing money, expressed as a percentage of the amount borrowed over a period of time. If you borrow £1,000 at an annual interest rate of 5%, you pay £50 per year for the use of that money. Looked at from the lender's side, it is the return they earn for providing the loan.
Interest rates exist because of three fundamental economic realities. The first is time preference: people generally prefer to have money now rather than later. If someone wants to borrow your money, they need to compensate you for giving up the ability to spend it today. The interest rate is that compensation.
The second is risk. When you lend money, there is always a chance the borrower will not repay. The interest rate includes a premium for this risk. Higher-risk borrowers pay higher rates.
The third is inflation. If prices are rising, a pound returned in a year will buy less than a pound today. Lenders charge an inflation premium to ensure they are repaid in real terms, not just nominal ones.
Not all interest rates are created equal. The base rate set by a central bank (like the Bank of England's Bank Rate) is the rate at which the central bank lends to commercial banks overnight. This is the anchor for all other interest rates in the economy. Mortgage rates, savings rates, credit card rates, and corporate loan rates are all set relative to this base, with spreads that reflect individual credit risk, term, and market competition.
Interest rates are one of the most powerful forces in the economy. They affect the cost of mortgages, the returns on savings, the borrowing costs of governments, and the valuation of virtually every financial asset. When rates are low, borrowing is cheap and asset prices tend to rise. When rates are high, the opposite happens.
Understanding interest rates is fundamental to understanding money, banking, investment, and economic policy.