Why is it always more beneficial to earn a higher interest rate on a smaller amount of money vs paying more towards a significantly higher amount of money with a lower interest rate?

Question

I wasn’t sure if this was more of a personalfinance question or an explainlikeimfive question–

This is something I’ve always struggled with in terms of understanding in a simple way. Why is better to put $1000/mo in a account that gets you 5% interest rate, vs putting an extra $1000/mo towards a loan (for $500k) that has a 3% interest rate?

I know the former is the better approach, but I can never get it to “make sense” in my head as far as why we wouldn’t want to reduce the much higher balance first (since 3% of 500k is still MUCH higher than what you would earn on an investment that’s only growing by $1000/mo, despite the higher interest rate)

In: Economics

Answer 1

I didn’t see this in the other comments, but taxes can complicate this, and they shouldn’t be overlooked.

You might make 5% interest by investing it, but you’ll lose some to taxes. The actual amount may wind up being closer to 4% afterwards.

If the loan you’re paying interest on is a home mortgage, you may be able to deduct that from your taxes. That may effectively bring down your interest rate.

At this point you’re supposed to sit down and figure those into the math, but I usually just split any leftover funds between the two options. There’s a personal satisfaction from paying down debt that’s difficult to quantify anyway.