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

Instead of thinking of the $500k loan as a single loan at 3%, think of it as 500 separate “mini” loans each at 3%.

You have $1,000. You can either pay off 1 of the mini loans at 3% or earn 5%. That’s it. That’s your choices.

The other 499 mini loans (or $499k total balance) will be there whether you put the $1,000 towards the loan or the interest opportunity.