Debt: Good debt and bad debt | Loans and debt | Financial literacy | Khan Academy

So let's talk a little bit about debt. Debt is just the amount of money that you owe, used in the form of loans. It could also be your balance on a credit card, which is really a loan from the credit card issuer.

I would say there is good debt and there is bad debt. Good debt is when you borrow money in order to make an investment of some kind that should produce more money than the amount that you are borrowing, and enough money to actually even offset the interest that you're going to have to pay on that debt.

Examples of things that might be good debt are if you are borrowing money to, say, buy a house because that will reduce your rent expense in the future, and the house itself might appreciate. Maybe you need transportation; you need a car or a motorcycle to get to your job, or you could get to a better job if you had that. You could work more hours because you're going to spend less time getting there. That could be an investment.

It could be you're going to invest in yourself. It could say, "Hey, I could take a course or I could get a degree." Yes, it's going to cost money, and then I'm going to have to pay interest on top of the money I owe, but it'll increase my actual job prospects and my income enough that it will more than offset that money that I have to pay in the future.

Even in those three or four scenarios, be very, very careful. If you're taking on student debt, really talk to people. Make sure that the degree program you're getting into and that line of work that you're getting into—the folks who decided to take debt on to do that—that it actually did pay off.

If you buy a car, make sure that it's something that really is an investment and not just something fancy that you want to show off to your friends. Because at some point, yes, it is transportation, but if you're starting to buy a very fancy car and you're borrowing money to do it, well, the fanciness of the car isn't going to necessarily increase your ability to get to work or to get a better job.

Then you're essentially taking on debt for a want as opposed to a need or an investment. Same thing with buying a house. It's not always the right decision. Oftentimes it can be, but really weigh what you think is going to happen, how much rent you're going to save, how much the house might appreciate. Sometimes they don't; they go down in value too, relative to how much you owe.

Make sure that it's something that you will be able to pay back over time, even if some bad things happen in life. You lose a job, or you have to spend money on an emergency in some way, shape, or form.

Now, on the other hand, there are things that I would categorize as bad debt. This is when you are borrowing money for things that, frankly, you do not need. Because when you do that, you're essentially taking money away from your future self. If you didn't have money today to buy it, and if you're going to have to pay that money back in the future with interest, you're putting your future self in a more and more difficult situation.

A very obvious category of this is, let's say there's a big fancy outfit you want to buy—one that will not help you get a job. You're like, "Well, I don't have the money, but it looks really cool. Let me buy that." Well, it might feel good now, but you're going to be paying that down for a very, very, very long time.

Or using debt to go eat at a fancy restaurant. If you're using money that you don't have, once again, it might be fun in the moment, but you're going to be paying that down and taking away from your future self, and it can lead to pretty sub-optimal or not so great situations.

There are folks that, if they start doing that, they take money from their future self. They see that their income, after they have to pay down the debt and the interest in the payments month after month, starts going lower and lower and lower. That’s a scary situation to be in. That will create a lot of stress and a lot of anxiety.

If you find yourself in a situation where you're borrowing to pay off other debt, that can also be a very big red flag, creating a lot of stress and a lot of anxiety. If, on things like your credit cards, you're just paying the minimum amount, but the balances aren't coming down, and you're usually paying very high interest on those credit cards, that is a very bad situation.

That is setting you up for not good financial outcomes. Maybe worst of all, whenever someone falls into one of these cycles, they might just say, "Oh, I just want to look at it. It just stresses me out." Then you don't, you're not even in a position where you're paying your debt or trying to ignore it.

That's going to hit your credit rating, and eventually, the collections folks are going to come after you. That is a very, very bad situation. Maybe you have to declare bankruptcy at some point in the future. So that can be useful, but be very, very, very careful with it.