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

3% of $500k is indeed a lot of money, but so is 3% of $499k.

When it comes to deciding if you’re going to put the $1000 towards paying down that debt what matters is how much interest you prevent by paying it down. In this case you go from 3% of $500k ($15,000) to 3% of $499k ($14,970). This move only shaves off $30 in interest per year.

By contrast, if you can put that $1000 into an account that earns 5% interest then that’s $50 per year.

In addition to the interest bearing account just being more money it also will give you more flexibility–if you have a sudden need for $1000 then it’s a lot less painful to pull the $1000 out of an account than it is to put it on a credit card with super high interest rate.