Sources of loans/credit | Loans and debt | Financial Literacy | Khan Academy

So let's talk a little bit about credit and lending. When I talk about credit, I'm literally just talking about someone's willingness to lend you money or to actually lend you money. You've heard of a credit card; when you buy something with a credit card, essentially the credit card issuer is lending you the money to make that purchase, and you're gonna have to pay that back at some future date, likely with interest, likely with a lot of interest.

Now, there's a lot of different types of loans or credit you can get, and they're going to have different costs associated with them. You're like, well, what's the cost of a loan? Well, sometimes there's just an outright fee associated with it, but more likely, on top of that, the interest that you pay on a loan is how much you pay. So if you're paying two percent interest for a loan, you're paying a lot less per dollar on that loan than if you had to pay, say, twenty or thirty percent interest. That might not seem like a lot—the difference between two and twenty percent—it's a ginormous difference. If you've watched our videos on compound interest, if you're paying twenty interest, or even ten interest, and if you're not paying down that balance pretty quickly, that could end up being a lot, a lot of money.

You could very easily end up paying a lot more in interest than the initial amount of money that you actually borrowed. Now, what are the scenarios where you're going to pay less, or when you're going to pay more? Well, we have whole videos on your credit score. The better your credit score, in general, the better a risk you look like you are to the lender, and so you're going to have to pay a lower rate, a lower interest rate, which is a good thing.

Now, above and beyond that, there's different types of loans. There are loans where if you aren't able to pay it back, the person who lent you money is still going to be able to get something. For example, if you take out a mortgage to buy a house, that's a loan and you have a down payment. If you aren't able to pay it back for whatever reason, the bank will foreclose and will take the house, and then they are likely to sell the house in order to get their money back. So there's some risk for the bank still; they have to go through all the trouble of foreclosing on the house. Maybe property values go down; that's one of the reasons why they make you put a down payment. That also protects them a little bit, but it's a lot lower risk than if they weren't able to get access to that house.

And so there, you're going to have to pay lower interest. Similarly, a car is a higher risk than a house, so you're probably going to have to pay a higher interest for a car loan. But if you don't pay, the bank will take the car and then sell the car. At the other end of the spectrum, I talked a little bit already about credit cards. You're just buying stuff, and if you don't pay back, it's going to be bad for you. The bank will really—they'll report to the credit bureaus, and it's going to hurt your credit score. Future people aren't going to lend to you, or they're going to charge a lot more to lend.

But from the bank's point of view, it's pretty risky, and so that's why they likely charge much higher interest. That interest can easily be in the teens or even twenties, even up to thirty percent in certain situations, and that is a lot of interest. That's why, in other videos, we talk about maybe paying down your credit card balances as quickly as possible.

Then there’s even more extreme things, like payday loans, which I don't recommend anyone watching this video use. Those are usually lenders, to some degree, taking advantage of people pretty desperate for money, where they're out of money. They need five hundred; they go to these payday lenders and they say, "Okay, we'll give you five hundred, but pay us five hundred fifty in three days when you get your paycheck." For some folks, that might not feel like a lot—okay, it's an extra fifty dollars. But if you actually think about that as an annual interest rate—I have a whole video on that—it's actually a ginormous interest rate. If someone does that consistently, and it's obviously not a great cycle to be in, you could end up paying a lot more to these payday loan lenders than you suspect.

So the big picture is credit can be a useful thing. Maybe you're making an investment, you're buying real estate, you need a place to live, you're buying a house, you need a car. These are all reasonable things, and it is okay, even sometimes, to potentially borrow for consuming things, things that you enjoy, but I would be a little bit more, a lot more careful with that. But the key takeaway is: the bigger a risk you are, the more that you're likely to pay for that loan.