Pay yourself first – What is it and how to do it

One of the most effective ways to build assets is to “pay yourself first”. The concept applies to reaching any financial goal you may have, whether it is saving for retirement, building an emergency fund, saving for a car, building an investment account, or really anything. Paying yourself first is critical to budgeting and building a solid financial footing.

The “pay yourself” first financial literacy concept is pretty simple. The basic idea is that the first item on your monthly budget is a fixed payment that goes toward your financial future – whether that be savings, a retirement fund, or a safe long-term investment. You can even decide to pay yourself first by investing into your career. You prioritize this payment over all of your other bills, even the absolute essentials like housing and food. But the payment to yourself on an automatic basis as well – make the payment In addition, never, ever buy a “want” before investing in you.

So what does pay yourself first mean?

It means setting aside money from each and every paycheck before you pay any other bills. The critical word here is BEFORE….you have to set aside some cash otherwise the entire concept falls apart. So before you pay any bill or expense you have for that month, or before you go to dinner or “treat yourself” to whatever, set aside some money each and every time you get paid. Save/invest it, and do not touch it. Ideally you want to automate this process by maybe having withdrawals from your employer into a 401K, investment account, emergency savings account, or any other resource you may be using to save.

A “pay yourself first” plan can even work for a low income family or one living paycheck to paycheck. The dollar amounts you invest/save will just be smaller; maybe even just a few dollars from each check. Teenagers, single moms, the disabled, and really anyone can pay them-self first, but the dollar amounts may be just a little less. However the concept probably isn’t going to work for those in dire financial straits (like the homeless), but it’s a good idea (and very frequently recommended by investment and retirement planning professionals) if you reliably have enough income to put something toward your savings.

Paying yourself first not only ensures that you’re always putting something away for your future on an automatic basis, but also helps to promote frugal and careful spending by immediately blocking out a chunk of monthly income that might otherwise go to waste. since the payment to you is automatic each pay period, you will not miss the money. This may be one of the most important lessons – it forces budgeting.

The need for a pay yourself first plan

America is simply not saving enough money for emergency expenses, let alone for the retirement years. According to the Bureau of Labor Statistics, the national savings rate is in the low single digits and may hover from 2 to 7 per year. In addition to that, 40% of Americans report not having enough money on hand to be able to meet a $400 emergency expense. Most are well under funded when it comes to retirement.

Not surprisingly, retirement savings are faring no better. The Government Accountability Office reports that almost 50% of American households have nothing at all saved for retirement, and over 25% of these households also do not expect to have a pension. 76% of all Americans worry that they will not have enough money to live off of in retirement. Paying yourself first can help address all of these financial challenges as well as others.

There is a definite need for a commitment to monthly savings for the future. However, pay yourself first plans fly in the face of some of the “conventional budgeting” wisdom from so called experts. The standard budget has you list your necessities out and take care of those first, then begin thinking about savings and investments. However for those people who want ti improve their financial standing in life, pay yourself first can help you do that. Along with compound interest and other tricks of the financial literacy trade.

For those literally living paycheck to paycheck with no wiggle room whatsoever, a pay yourself first plan may not be feasible in large dollar amounts – they may be only able to pay a few dollars to their goals. If you have any spare income and any thoughts about saving it, however, this plan can be highly effective. And it doesn’t necessarily require a big monthly commitment; any amount that you can free up helps.

Once you set the money aside, and have paid yourself first before any other bills, use those funds which you set aside (paid yourself) to meet your financial goals. If your goal it to buy a house, then put that money into a dedicated account for the house. If your goal is to save for retirement, then invest it in your 401K or IRA or other retirement account. If your goal it to build long term wealth, this approach will help. Put this money aside and never tough it no matter what. In effect almost pretend it is not there. If you need some help in doing this, use your smartphone. There are tons of free budgeting apps that will help you set aside money to pay yourself first.

Paying yourself first forces better financial decisions around spending

What normally happens is people do not even notice the “missed” money in which they paid themselves. It in effect forces you to live smarter and often make better financial decisions, all the time while your money is hopefully working for you in the investment, savings, account, or wherever you saved it. The money can compound and grow, as we have reported on.

Paying yourself first may leave less money/cash in your pocket for that week or pay period, but that is OK. It in some ways forces you to budgeting. That is what it the concept should do. Then you will be forced to think more and adjust your spending accordingly. For example, if you pay yourself first, maybe when the time comes to buy that $6 latte at Starbucks you will realize “Hey, I do not have the same amount of money in my pocket this week” as the few dollars you normally would have had been set aside in your investments from the pay yourself first approach. Then maybe you will pass on that $6 latte, or maybe buy a $3 coffee instead. You will soon automatically budget and treat your money more appropriately.

Discipline becomes a habit

You need to be disciplined to pay yourself and follow this rule. When it comes to financial or career matters (working, investing, launching a business, budgeting, etc.) I am a big believer in discipline. “Force” yourself to do it every time, and eventually it becomes a habit. Discipline is a trait that most successful people have, whether they are in business, actors or actresses, singers, parenting and setting examples for a child, or whatever. Build a habit of paying yourself first. On a side note, discipline leading to habits really applies to anything in life. People trying to lose weight, someone learning a new skill or hobby, etc. It starts with discipline to do the activity, then it becomes a habit.

Now we understand the concept of paying yourself first can be difficult for some people to do or comprehend, especially for families who are lower or even moderate income, who may be living paycheck to check and are not familiar with budgeting. While it can be difficult, it can still be possible to pay yourself no matter what your income is. Even if you live in poverty just set aside a dollar. Or set aside some “cents” each pay period. Just set aside something to get into the discipline of doing this.

Then, as time goes on, if you are in the habit of paying yourself first (no matter your household income) ideally over time you can increase the amount saved. Even a low income family maybe starts with a dollar each paycheck. Then they see maybe saving a $1 doesn’t “break the bank” so they eventually increase it to a $1.50, then $2, etc. Then, over time, paying yourself first can add up, even for families who are struggling just to pay the bills.

The importance of an automatic payment to yourself

One of the keys to making this plan work is an automatic deduction to your savings account or investment vehicle every month. If you have to approve a manual transfer, it is too easy to forget about it or find reasons to say “maybe next month.” Kids and those working part time, like teens, can even pay themselves on an automatic basis.

The first thing to do is to decide what your savings goal is. The basics of financial literacy can help you set these priorities. If you don’t have emergency funds, that’s the first priority. And stashing money away for retirement would be a close second. From there, a pay yourself first plan can be applied to all sorts of optional savings goals – for example, perhaps a new car or a new home.

The simplest thing to do is have a fixed percentage of a direct deposit paycheck automatically routed to savings when it comes in. Many experts recommend the “50/30/20 rule,” which is a good place to start if you’re not sure how to begin saving. This rule basically says that 50% of your income should cover “needs” (like rent and food), then the remainder is split between 30% to “wants” (like dining out or seeing a movie) and 20% to your savings goals. Read more on spending on needs vs wants.

Of course, you can adjust these numbers as needed. If money is tight and you’re having trouble squeezing 20% out of your “needs” category alone, consider starting with 5% or 10% instead. Even a small amount like 5% gets you in the habit, and it can always be bumped up later when the income situation is better. So you can also tweak those guidelines as well.

Regardless of the dollar amount, every little bit helps. Even saving a dollar or two per day adds up. The paying yourself first approach to saving, even $2 a day, can be used to start to fund a retirement account. Or start/add to emergency savings. It is a powerful concept. Learn more on how saving $2 per day adds up.

Tricks to free up money to pay yourself with

One of the keys to being able to pay yourself monthly is to make it automatic. That way you will not “miss” the money as it goes right into savings or investment before you even see it in your paycheck. Or you can free up some money with cutbacks on existing expenses. In other words, budget.

Obviously, the “wants” category of expenses is the first place to look. It’s usually not a good idea to totally eliminate this sort of spending, as it’s important to mental health and happiness. But it’s also usually the place where the greatest amount of wiggle room as well as potential savings exists. Maybe you could downshift to a less expensive version of a midday treat, or do some savvy shopping at a thrift store to cut into clothing spend.

The “needs” category can be worth looking at as well to free up money to pay yourself. For example, is it possible to get a better interest rate if you’re carrying debt? You might be able to renegotiate, or move credit card debt onto a card with more favorable terms. Comb over the food bill to look for places to get the same item at a lower price. See if there’s a more affordable phone or internet plan that works for you. And if late fees tend to be a problem for you, look into setting up automatic payments. These are just a few ideas to get the creative juices going.

Making your savings go farther

A basic savings account is fine for emergency funds as part of the pay yourself principal. If you’re aiming for bigger goals, like retirement or a home purchase, it’s time to start looking at more specialized products with better yield or potential for long term investment returns.

For retirement, the go-to instrument for putting money away for yourself is the IRA. Or use a 401K at work if your employer matches. There are a number of different types, but the two that most people use are the traditional and the Roth. The difference between the two is that you’re taxed now on the Roth and later (when you cash out) with the traditional. So it comes down to your current income situation, plus how much money you expect to have in retirement relative to right now.

Other safe-and-steady alternatives to consider for your savings goals include an online high-yield savings account, a certificate of deposit (CD), a cash management account or a money market account. Or you can even pay yourself first into a stock based investment account, and that may be the best option for teenagers, students, and the younger generation. As if they pay themselves early, the money has time to grow as well as compound.

Benefits to paying yourself first

It forces you to put your own middle to long term financial needs and goals first. It forces savings, investments, wealth building, contributions to retirement, and looking out for your financial future. Anyone can pay themselves first, and it is never too late to start. A family, even a low income one, can start to building investments using apps from the money they saved. Learn more on how low income families can start investing.

So go ahead, start to budgeting and even force is by starting to setting aside some of your next paycheck. Save it, invest it, or whatever. Pay yourself first, and take care of your financial future and goals.

By Jon McNamara