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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, updated on October 4th, 2023       

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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

Common questions about how personal loans work

What are comparison rates on personal loans?

These are combined figures which incorporate the interest rate and key fees on a given loan. This is designed to give you a more accurate representation of the cost of your loan, with interest not always painting the full picture. As such, you should always compare based on comparison rates.

Can I make additional repayments on my loan?

Yes – most loans, including those from our lending partners, will enable you to make free additional repayments. These are highly useful, as making these repayments will reduce your principal more quickly, thus cutting down on the overall interest you’ll pay.

Will my interest rate be fixed or variable?

Both fixed and variable rate loans are offered by financiers. Fixed rates are more common and come with the benefits of stability across your loan and usually starting from lower base rates. Variable rates are open to fluctuation across your repayment term, which can enable you to capitalise on rate drops but don’t protect against rises.

Am I able to choose any length of loan term I like?

Not necessarily – like your borrowing power, lenders will approve your loan over a term they feel you can comfortably and reliably repay over. Your monthly disposable income will largely inform the size of repayments you can take on. Additionally, because longer-term loans are seen as riskier in general, these are often reserved for customers with strong borrowing profiles.

What fees are present on personal loans?

Several fees may be charged on your loan. However, it’s important to note that these aren’t always charged, as some of our lending partners can offer no-fee deals. The main fees which apply to loans are:

  • Establishment fee: $0 to $595
  • Ongoing fees: $0 to $10
  • Early repayment fee: $0 to $600+ (depending on time left to run on the loan)
  • Late repayment fee: $15 to $35
Will my credit score be affected when I apply?

Yes – your application will be listed on your file once it’s been submitted and processed. However, we work with lenders who can supply you with an indicative interest rate before formally applying which won’t affect your credit score or file.

Helpful personal loan guides