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

Percentages are percentages, the $ amount doesn’t matter.

If putting money towards Investment A earns you 5% after tax and paying extra on Loan B saves you 3%, then your money is better off in Investment A, minus any personal feelings on holding debt.

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Example time:

Let’s take a $200k loan @ 7% over 30yrs, if you put $105/mo extra you would save ~$65630 over 24yrs.

If you took $105/mo earning say 9% after-tax, that would be ~$70440 in interest over 24yrs.