What is a loan? What it means, how it works, and what to watch out for

At some point in life, most people consider taking out a loan — whether to deal with an emergency, invest in something important, or simply organise their finances. That’s why it’s essential to understand what a loan is, how it works, what its key features are, and what precautions to take before applying.

This article outlines the main types of loans, their advantages and risks, when it’s worth considering one, and how to compare different offers to find the best option for your financial profile.

What is a loan?

A loan is a sum of money provided by a financial institution — such as a bank, credit union or fintech — with the obligation to be repaid in the future. Repayment is made in fixed or variable instalments over a set period and includes interest charges.

The principal is the original amount borrowed, while the interest is the cost charged by the lender for providing the money. Loan repayments can be made through fixed or variable instalments, depending on the agreement signed between the parties and the interest structure chosen.

When is a loan a good option?

A loan can be helpful in a range of situations — as long as it’s used with careful planning. Before applying, it’s essential to review your financial health to better understand your current situation, as well as your future goals and priorities.

Some circumstances where taking out a loan might be worth considering include:

• Debt consolidation: combining multiple debts into one, ideally with a lower interest rate.
• Purchasing durable goods: such as a car, furniture or household appliances.
• Home or vehicle improvements: covering renovations, repairs or upgrades.
• Investing in education: for example, technical courses or university degrees.
• Emergencies: including medical expenses, job loss or unexpected events.

It’s also important to remember that a loan should not be treated as an extension of your regular income. It is a financial commitment over time and should be considered with care and responsibility.

Types of loans

1. Personal loan

This is the most common form of credit available. In general, a personal loan can be used for almost any purpose and doesn’t require you to explain how the money will be spent. Loan amounts can vary widely — from small sums to larger figures — depending on the lender and even your personal credit history.

A personal loan may be:

• Secured: where you offer an asset, such as a car or property, as collateral. This often results in a lower interest rate due to the reduced risk for the lender.
• Unsecured: where no collateral is required, but the interest rates are usually higher because the lender is taking on more risk.

Check out our website for some practical tips on how to apply for this type of loan.

2. Salary-based and account-linked loans

In Australia, there are some financial solutions linked to your salary or bank account:

Salary advances

Some employers offer staff the option to access a portion of their wages early, with no interest or fees. This may be formalised as an internal employee benefit, or made possible through fintech platforms that use pay-on-demand models.

Direct debit

Widely used across the country, direct debit is an automatic method of deducting loan repayments directly from the borrower’s bank account on the agreed date. While it simplifies the repayment process and helps maintain a good credit history, it is not linked to payroll, and the bank does not withhold any part of the borrower’s wages directly. It’s important to ensure your account has enough funds on the due date to avoid missed payment fees.

3. Financing

Financing is a type of loan specifically linked to the purchase of a particular item — such as a property, a car, or high-value equipment. In most cases, the item being purchased serves as collateral for the loan.
This type of credit typically comes with longer repayment terms and lower interest rates compared to a personal loan. However, it usually requires more detailed documentation and a thorough credit assessment.

4. Credit Card

Although not a traditional loan, credit card debt — especially when using the revolving credit facility (where the full statement balance isn’t paid by the due date) or installment plans — represents a form of borrowing.
These forms of debt often come with very high interest rates, so they require careful planning and responsible use to avoid financial difficulties.

5. Overdraft

An overdraft is a pre-approved credit limit linked to your everyday transaction account. It can be used automatically when your account balance drops below zero, effectively working as a short-term loan.
However, overdrafts usually attract some of the highest interest rates on the market. For that reason, they are best reserved for emergency situations and should only be used for short periods of time.

6. No interest loans

Designed for people experiencing social or financial hardship, no interest loans are generally offered by community organisations and not-for-profits. These loans do not charge interest or fees, and typically come with simple eligibility criteria and a quick approval process.

They are intended to help cover the cost of essential items, such as furniture, white goods, medications or emergency home and car repairs.

Interest: fixed or variable?

When taking out a loan, you can usually choose between a fixed interest rate or a variable interest rate:

• Fixed interest: The rate remains the same for the entire term of the loan. This offers predictability and greater control over your budget.
• Variable interest: The rate may fluctuate over time depending on changes in market rates. This can be beneficial if rates go down — but risky if they increase.

Tip is to check whether your loan agreement allows for early repayments without penalty. Making extra payments can help you pay off the loan faster and save on interest.

Factors that influence the interest rate

The interest rate offered on a loan can vary depending on several factors, including:

• Your credit score
• Monthly income and financial stability
• Repayment history
• Assets offered as collateral
• Your relationship with the lender

The rate advertised by a lender is not always the rate you’ll receive. Most loan offers include a minimum and maximum interest range, depending on individual risk assessments. That’s why it’s essential to run a loan simulation or pre-approval check before committing to a deal.

How to compare loans

Before signing any loan agreement, it’s essential to compare the different offers available in the market. Consider the following factors:

• Comparison rate: The overall cost of the loan, including the interest rate and most associated fees. This is a more reliable indicator than looking at the interest rate alone.
• Interest rate: The percentage charged on the amount borrowed.
• Application and maintenance fees: Upfront and ongoing charges that may apply depending on the lender.
• Extra repayments: Some lenders charge a penalty for making early repayments. Check the terms if you plan to pay off the loan sooner.
• Loan purpose: Some loan products are limited to specific uses, such as purchasing a vehicle or making home improvements.
• Loan term: Shorter terms usually reduce the total interest paid but result in higher monthly repayments.

Be cautious when using comparison websites. Many are sponsored by commercial partners and might not include all available options. Always read the full terms and conditions before making a decision.

How do you know if you can afford a loan?

Before taking out a loan, it’s important to plan your finances carefully and ask yourself:

• Review your monthly budget and assess whether you truly need a loan.
• Evaluate your ability to make repayments without compromising essential expenses for the entire loan period.
• Use a loan calculator to simulate how the new debt would impact your overall financial situation.
• Set up an emergency fund so you’re not relying solely on credit when unexpected costs arise.

Managing your loan repayments

• Staying on top of your loan repayments is crucial to avoid extra charges and protect your credit history. Here are a few tips:
• Make sure you have enough funds in your account on the repayment date.
• Avoid late payments — fees and interest can add up quickly.
• Try not to take out additional loans before paying off the current one.

If you’re having trouble keeping up with repayments, contact your lender as soon as possible. You may be able to renegotiate the terms or request a temporary pause. There are also free financial counselling services available to help you manage debt and create a sustainable repayment plan.

Loan scams and risks

Loan scams are common — especially during times of financial stress. Be alert to warning signs such as:

• Offers of credit that seem too easy or urgent.
• Requests for upfront fees before you receive the loan.
• Websites or social media profiles with no official registration or verifiable contact details.
• Unlicensed lenders operating without regulation.

Never share personal or banking information unless you’re certain the lender is legitimate. Always deal with licensed credit providers and check their registration through the ASIC website or other relevant regulatory bodies.

Conclusion

A loan can be a useful tool when used with planning and responsibility. It can help solve a financial issue, fund a personal goal or support an important investment. But it also comes with a long-term commitment that should be approached with caution.

Before making any decision, take the time to do your research, compare your options, read the contract carefully, and consider alternatives.

And remember: the best loan is the one that fits your budget without compromising your financial peace of mind.