What is a Personal Loan and How Does It Work?

In Australia, personal loans are a significant part of the financial landscape, providing individuals with a structured way to fund everything from a new car to a long-awaited holiday or debt consolidation.

Household debt, which includes personal loans, has grown substantially over recent decades, reflecting their common use in managing personal finances.

Essentially, a personal loan is a sum of money you borrow from a lender—such as a bank, credit union, or online provider—and pay back in regular instalments (repayments) over a set period, typically with interest.

The Australian Prudential Regulation Authority (APRA) oversees the stability of lenders, ensuring they operate responsibly, while the Australian Securities and Investments Commission (ASIC) regulates the consumer protection aspects through the National Consumer Credit Protection Act.

This guide will break down the different types of personal loans available in Australia, how the application process works with crucial checks like responsible lending obligations, and what you need to know about interest rates and fees to make an informed decision.

Understanding these mechanics is key to using a personal loan effectively and avoiding unnecessary financial strain.

Here’s a step-by-step breakdown of how they work.

1. The Basics: Key Components of a Personal Loan

Before you apply, it’s crucial to understand these four terms:

• Principal: The original amount of money you borrow.
• Interest Rate (APR): The cost of borrowing the money, expressed as an annual percentage rate. The APR includes both the interest rate and any fees, giving you the true annual cost.
• Loan Term: The length of time you have to repay the loan (e.g., 24, 36, or 60 months).
• Monthly Payment: The fixed amount you pay each month, which includes a portion of the principal and the interest charges.

2. The Application Process

Getting a personal loan involves a formal application and approval process.

• Check Your Finances: Review your credit score and debt-to-income ratio (DTI). Lenders use these to determine your eligibility and interest rate.
• Shop Around: Get pre-qualified offers from multiple lenders (banks, credit unions, or online lenders). Pre-qualification lets you see potential rates without a hard credit check.
• Submit a Formal Application: Once you choose a lender, you’ll submit a full application. This requires documents like pay stubs, bank statements, and proof of identity.
• Receive a Hard Credit Check: The lender will perform a hard inquiry on your credit report to make a final decision.

3. Receiving the Funds

If you are approved, the lender will disburse the loan.

• Lump-Sum Payment: The full loan amount is deposited directly into your bank account, usually within a few business days.
• Designated Use: While some loans are for specific purposes (like a car), personal loans are often versatile. You can use them for almost anything, such as consolidating high-interest debt, financing a home renovation, or covering a major unexpected expense.

4. Repaying the Loan

This is the most important phase, where you fulfill your agreement.

• Fixed Monthly Payments: You will make the same payment amount every month for the entire loan term. This makes budgeting predictable.
• Amortisation: Each payment covers both interest and principal. Early on, a larger portion of your payment goes toward interest. Over time, more of each payment goes toward reducing the principal balance.
• Autopay: Many lenders offer a slight interest rate discount if you set up automatic payments from your bank account.

5. What Happens When the Loan is Paid Off?

Once you make the final payment, the loan is closed.

• Account Closure: The lender will close your loan account and send you a confirmation.
• Credit Impact: Successfully paying off an installment loan can have a positive impact on your credit history.

Advantages and Disadvantages of Personal Loans

Advantages:

1. Debt Consolidation: Can simplify multiple debts into one payment, often at a lower interest rate.
2. Predictable Payments: Fixed rates and terms mean no surprises in your monthly budget.
3. No Collateral Required: You don’t risk losing an asset if you default (though there are serious consequences).
4. Fast Funding: Compared to other loans, funding can be very quick.

Disadvantages:

1. Interest Rates Can Be High: For borrowers with fair or poor credit, rates can be higher than credit cards.
2. Fees: Some loans come with origination fees (a percentage of the loan amount) or prepayment penalties.
3. Potential for Debt Cycle: Using a loan irresponsibly can lead to more debt.
4. Credit Impact: A hard inquiry during application can temporarily lower your credit score.

In summary, a personal loan is a flexible financial tool that provides upfront cash for a variety of needs, which you then repay in steady, manageable instalments.

Its value depends heavily on your creditworthiness and using it for a financially sound purpose.