As I understand that the loopback interface(127.0.0.1) is used to route packets back to the source. How is it then used to talk to iBGP neighbors? I understand that the goal is to ensure that the interface doesn't go down, so using an emulated/software interface ensures that, but how to packets go out of the host on a loopback interface (and isn't it against the definition of loopback interface?). Thanks in advance.
Use of Loopback interface in iBGP
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iBGP uses interior routing protocol to route the packet between the iBGP nodes. It doesn't/can't use the loopback interface. It uses whatever physical interface that is up and leads to the destination.