How Do Personal Loans Work?
Learn the ins and outs of personal loans and compare from the best offers on the market with Savvy today.
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What are personal loans and how do they work?
Personal loans are a type of finance designed to be used for any sort of private purpose you wish. Whether you’re looking to consolidate other high-interest debts, pay for expansions or improvements around your home, cover unexpected medical costs or even receive a helping hand with your wedding, you’ll receive a set lump sum with which to cover your expenses. You’ll then repay this over a loan term of your choosing, with lengths available from one to seven years to fit your personal repayment needs.
It’s important to understand the two key aspects of a personal loan: the loan amount (or principal) and interest.
The principal is fairly self-explanatory: this is the amount that you’re requesting to borrow from your lender, which will vary between each applicant. The interest, on the other hand, is calculated with a slightly more complex equation. This is the primary way lenders make money on their personal loans and essentially serves as a premium being charged for enabling you to access your funds earlier than you otherwise would be able to. Interest is calculated based on your remaining loan principal daily, meaning the interest you pay each month is an accumulation of 30 or 31 daily calculations. It’s calculated as follows:
- Loan amount multiplied by (interest rate divided by 365) = daily interest
Using this formula, you can work out what interest you’d pay in a given month. For instance, on a personal loan with a balance of $30,000 and interest rate of 10% p.a., your monthly interest would be as follows:
- $30,000 x (0.1 ÷ 365) = $8.22 daily interest
- $8.22 x 30 days = $246.58 monthly interest
Because your loan principal reduces over the life of your loan, you’ll pay less and less interest as your repayments go on. Your repayments will remain the same, though, meaning that each instalment will have a gradually greater proportion of principal and a lesser portion of interest.
How much can I borrow with a personal loan?
You can borrow any amount from $2,000 up to $75,000 with a personal loan in Australia. However, there’s a range of factors which can affect your borrowing power, which will be different for every applicant. When it comes to assessing this, lenders view applications through the lens of risk: effectively, what the likelihood is their loan amount will be repaid without any issues. The factors that play into this include:
Credit score
This figure tells your lender how reliably you’ve been able to repay debts in the past. Timely and full payments for other loans, credit card debts and household bills will help increase your score, while late payments and prior defaults will lower this score. The higher your score, the more reliable your lender will view you as and the more likely you are to be approved for a higher loan amount. This will also result in a lower interest rate.
Income and affordability
Above all else, the loan that you’re applying for needs to be affordable for you consistently across your term. Your lender doesn’t want to see your income fluctuating wildly month to month; consistency is key here. It goes without saying, of course, but the more you earn, the greater the loan sum and repayments you’ll be able to take on.
Employment stability
The type of work you do will also play a role in determining your borrowing power. This comes back to consistency from the previous point: your lender wants to see that your income will remain stable and won’t run dry during your loan term. How long you have to work to get your personal loan varies: borrowers with long-term full-time or permanent part-time employment can usually be approved from the day they start a new job (provided they've come from another similar position with a similar salary), while casual employees and sole traders will need at least six months and two years in their role, respectively, in which they’ve earned consistent income.
What types of personal loans are there?
The other key factor to consider is the type of loan you’re looking to take out, with the two main options revolving around loan security in unsecured and secured personal loans.
Secured personal loans
How a secured personal loan works is simple: you put up a valuable asset as collateral for your loan and reap the rewards. Security on personal loans will help extend your potential borrowing range to $100,000 (depending on your borrowing power and asset value) and reduce your interest rate. The asset you use can be your car, motorbike, caravan or boat, which will be sold to recoup funds for your lender as a last resort if you default on your loan. These loans tend to come with a higher minimum of $15,000.
Unsecured personal loans
As you can guess, unsecured loans avoid the necessity for loan security. They come with a potential borrowing range of $2,000 up to $75,000 and present as a great option for borrowers without an asset deemed eligible to serve as security, or those who simply prefer not to do so. They’re generally faster to process because of this and are available from a wider range of lenders.
The personal loan application process
Comparing your options
This is the first step when you’re looking to secure a personal loan. Some of the important things to consider when comparing different loan products are:
- The loan amount
- The interest rate as well as other fees charged e.g. application, ongoing and late payment charges
- The available terms of the loan
- The repayment flexibility of the loan (whether it'll penalise you for completing your loan repayments ahead of schedule)
Make sure you're eligible
The eligibility criteria for personal loans varies depending on the lender, but the most common qualification terms are:
- Be at least 18 years old
- Be an Australian citizen or a permanent resident
- Have regular, stable income of at least $20,000 to $26,000 annually. Centrelink benefits may be counted towards your income by some lenders
- Have no history of defaults or bankruptcy
The information you'll need for your application
The process of applying for your loan can also differ from one lender to another. Some of the information and documentation that lenders ask borrowers to provide include:
- A driver’s license, passport, or ID
- Your online banking details
- Your last two payslips (or two most recent years of tax returns if you're self-employed)
- Evidence of assets and liabilities
- Proof of address in the form of a recent utility bill
Loan Approval & Repayment
Once you've submitted your application, you can receive an outcome as soon as 60 seconds after you apply. If your application is successful, your lender will send through a loan contract for you to sign electronically and return to them.
After this has been received, your lender can advance the funds directly into your account, which you can then use for whatever purpose you may need. You'll begin your repayments after the next week, fortnight or month depending on the schedule you chose.
