How do personal loans work?

Personal loan features vary across different lenders. Understanding the different building blocks of a loan is important in helping you compare and choose the right personal loan.

What to look for in a personal loan

Interest rate

The interest rate, also known as Annual Percentage Rate (APR) or Advertised Rate, is the percentage that you’ll pay on top of the amount you borrow in interest, usually expressed as an annual rate.

Interest rates vary depending on the lender, your credit history, your repayment schedule and a range of other factors. They are based upon the lender’s calculation of risk (for you as an individual and the market as a whole) and their underlying costs.

Many lenders market their products using a ‘headline’ advertised rate, which represents the best rate they are able to offer a customer. Often this low rate is available to only a small proportion of borrowers. Before you apply anywhere, it pays to do your research and get a personalised rate from a number of providers. You just need to make sure that the lender’s quote process is ‘credit score friendly’. That is, they only conduct a soft check on your credit file, which won’t impact your credit score.

The competitive nature of the personal loans market in Australia means it pays to shop around for a better rate. That being said, the lowest interest rate does not necessarily mean the best loan. You need to consider the total cost of the loan, including interest, fees and other costs to truly assess the value of any interest rate on offer.

Comparison rate

The comparison rate represents the overall cost of a loan, including the interest rate and fees, expressed as an annual percentage. As a result, the comparison rate is usually higher than the interest rate charged on the loan.

Under the National Consumer Credit Protection Regulations, lenders must provide a comparison rate when they advertise an interest rate. This was introduced to stop lenders from advertising lower rates when the total cost of the loan would be significantly more once fees and other costs were included.

For personal loans, there is a standardised measure for how comparison rates are calculated.

Whilst the comparison rate is a useful tool for comparing personal loans on a like for like basis, it’s important to remember that not all costs are included. For example, you still need to consider:

• Late repayment fees
• Early repayment fees
• Deferred establishment fees

Repayments

Your repayments are the amount you agree to pay to your lender on a regular schedule. Repayments can be weekly, fortnightly or monthly and vary by lender.

Whereas interest rates and comparison rates can sometimes hide the true cost of a loan, your monthly and total repayments provide a clear basis for comparing the value of personal loans from different lenders. When making your comparisons, however, it is important that the loan repayment calculations have been quoted inclusive of any ongoing fees for all lenders.

Upfront fees

Upfront fees, also known as establishment fees or credit assistance fees, are ‘once-off’ charges that are applied at the commencement of a personal loan. These fees can be:

• A flat fee (e.g. $150) that applies regardless of the value of the loan
• A tiered fee (e.g. $250, $500, $750) based on the total amount borrowed
  
• A percentage fee (e.g. 4%) based on the total amount borrowed and the credit risk of the customer
  
• A hybrid fee (e.g. $200 + 2% of the loan amount)
  

Upfront fees are usually capitalised to the loan. This means the upfront fee is added to the amount you wish to borrow. For example, if you are borrowing $10,000 with an upfront fee of $300, the total loan amount on commencing the loan will be $10,300.

Why is this important? Well – that interest rate you are being offered will be applied to the total loan amount – inclusive of your upfront fee. In the case of a small upfront fee, the difference might be a few dollars on each repayment. On an upfront fee of 4%, however, you could be paying $1,200 on a $30,000 loan, meaning you will be charged interest on a $31,200 balance. Ouch!

If you’re considering a lender with a low interest rate, it’s important you check to make sure there isn’t a high upfront fee that outweighs the benefit of the lower rate. This is particularly true of percentage-based fees that flex with the amount being borrowed. Checking the comparison rate and the proposed repayments will allow you to assess this compared to other lenders.

Ongoing or monthly fees

Ongoing fees, also known as account keeping fees or loan management fees, are fees that are paid every month across the life of the loan – without reducing the amount you owe. For example, a $10 monthly fee on a 5-year loan adds up to $600 across the life of the loan. That’s a lot of money that’s not going to repaying your loan principal.

Like all fees, the presence or absence of monthly fees is all relative to the total amount you repay over the life of the loan.

Banks and larger lenders often have lower upfront fees that are offset with a monthly fee of $10 to $13. This means the net cost of the upfront fee and the monthly fee may be higher than you otherwise would have paid for a lender with a higher upfront fee and no monthly fees. In the end, it pays to do the math on ongoing fees before you commit to a particular lender.

Early repayment fees

Repaying your loan as quickly as possible is a clever strategy as it will reduce the overall amount of interest you pay on your loan. However, if you do find yourself in a position to do this (well done!), the last thing you want is to be hit with an early repayment fee (also known as an exit fee).

Early repayment fees can range from $0 up to $800 or a % of the loan value on repayment, with $150-175 being the most common fee. That’s a fair amount for you to pay for doing something that is good for you. Therefore, it pays to read the fine print on fees before you commit to a loan.

It’s worth noting that some lenders have set conditions that trigger an early repayment fee that varies with the type and duration of the personal loan. For example, unsecured fixed interest rate personal loans with the banks often have far stricter early repayment terms than for their variable-rate loans. Lenders with no early repayment fees ultimately provide you with the highest degree of flexibility in how and when you repay your loan.

Penalty fees

We all know we should try to avoid penalty fees at all costs — it’s just throwing your money away — but we’ve all missed a direct debit from time to time. That's why you should always make sure you are aware of any penalty fees and make sure they are not too onerous.

The most common penalty fee associated with personal loans is the ‘default’, late or missed payment fee, which usually arises where there are insufficient funds in your nominated account on the day a payment is due. Late payment fees range from $20 to $35, however, some lenders will waive the fee if the account is brought up to date within 3 days.

It can help to make a budget of your expenses before you agree to the loan so that you know that you’ll comfortably be able to make repayments. You should also consider opening separate savings accounts to transfer funds into each payday that separate from your daily transaction account to ensure funds are always available.

When it comes to penalty fees, it is a case of buyer beware. Always take the time to read the loan terms and conditions and look out for any other hidden fees, including ‘new age’ penalty fees like charges to receive paper statements.

Loan amount

The loan amount is how much you intend to borrow. This is the principal amount upon which interest is paid (plus any upfront fees). In Australia, lenders have a minimum loan amount and maximum loan amount that they accept. These generally range from $2,000 to $65,000, although a small number of lenders may lend up to $100,000 for individual and joint applicants.

Within the advertised range, however, most lenders apply loan capping rules. This means they adjust the maximum loan amount you may be eligible for based on your credit score, income, mortgage status and a range of other factors. This maximum loan eligibility will usually be communicated to you when you get an initial quote or rate estimate from a lender.

Even once you have applied with a lender for a specific loan amount, they may come back to you with a ‘counter-offer’. A ‘counter-offer’ is a conditional approval based on a loan amount that is lower than the amount you’ve requested but one the lender believes you can afford and meets their responsible lending requirements.

Whilst it may be tempting to borrow as much as you can, make sure your repayments will be realistic to make within your budget. This will be a significant factor in determining whether your loan will be approved.

Loan term

The loan term represents the length of time it will take to repay the loan in full with a regular repayment schedule. In Australia, lenders offer terms from 6 months to 7 years, with 3 and 5-year terms being the most common. A longer-term loan will usually attract a higher interest rate and the loan will cost you more overall but your repayments will generally be lower.

Customer experience

All lenders operate differently. So whilst customer experience isn’t a traditional product feature, it does go a long way to determining how quick and easy it is to apply, get approved and manage your loan. Trusting you are getting the best deal, a lender who cares about your experience should be a key factor in your decision.

The best place to start doing your homework is to check out reviews on third-party websites that provide independent and verified feedback about customers' experience with a lender. They tell you a lot about the customer experience at an aggregate level more than any list of features and attributes might. Product Review, TrustPilot and Google Reviews all provide insights into the best performing personal loan providers.

Each year, Canstar assesses and ranks 100s of personal loans to help borrowers to decide which ones will be awarded a 5-star rating. In addition to rating the overall product’s value (80% of the score), Canstar’s ratings also attribute 20% of the rating to the loan’s features. This includes Loan Management and Customer Service and Support. For a loan to get a 5-star Canstar rating, the lender has to provide great customer service and tools, such as an online portal for managing your loan and repayments.