What the loot filter does
Metin2 drops a lot when you kill monsters: potions, equipment, upgrade materials, event items and Yang among them. Without a filter you pick all of it up, and after a few hours of farming your inventory is full of things you never wanted. The loot filter decides which items get collected, so only the drops you care about end up in your bag.
Where the settings file goes
The Metin2Alerts wiki says to put the filter file into the UserData/looting folder inside your Metin2 directory. That is the folder the page names for the filter, so a file dropped anywhere else simply will not apply.
The categories you choose from
The wiki's tool lists these loot categories: Weapon, Armour, Helmet, Miscellaneous equipment, Costume, Dragon Stone Alchemy, Unique, Refinement, Potions, Fishing and Mining, Mounts and Pets, Skill Book, Other item and Event item. Pick the category that matches what you are farming, or search for the item you want and the tool shows which category it sits in.
How to set it up well
Build the filter around the items you actually need instead of ticking everything. The wiki's advice is to start from the material or item you are chasing, then change the selection when you switch to farming something else. Because junk never enters your inventory, you spend less time selling or dropping items in the middle of a farm, and valuable drops are easier to spot in a crowded spot.
Who it helps most
The wiki names farmers grinding for hours, Metin stone hunters, high level characters in busy farming areas, event players chasing specific drops, and anyone who wants a tidier inventory. That list is the wiki's, not a claim about your server.
Sources
Metin2Alerts Wiki: Loot Filter (what it does, the settings folder, the loot categories)