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

If you put $1000 toward a 500k loan, then you have a 499k loan. So yes, while the amount of interest on a 500k loan is a lot, the amount of the loan only changes by $1000 (500k to 499k). So what matters is what changes, so the comparison should be $1,000 in a 5% interest bank account or $1,000 less on a 3% interest loan.