There’s a reason why "pay yourself first" is considered an important piece of financial wisdom -- it’s a principle that makes sure you’re managing your money before spending it on bills.
It sounds great in theory, yet it’s easier said than done.
No sooner do you get your paycheck in hand than the majority goes to your rent or mortgage payment, your student loan payment, your car loan, your credit card balance, gas, groceries, the cable and electric bill, etc. Saving becomes something you do after the fact, if there’s even enough money left over. Sounds more like paying yourself last.
Paying yourself first makes saving money a priority without sacrificing your other financial needs. No matter what your earning status or responsibilities are, you can afford to pay yourself first with a few small changes.
What is paying yourself first?
Paying yourself first should really be called investing in yourself first.
It’s simply another type of budgeting that sets aside a specific portion of your income to saving. You’ll build your budget like you always would -- determining your monthly income and expenses together -- but you’ll devote a certain dollar amount to saving, i.e. paying yourself, and you’ll do that first before spending money on anything else.
Take this as an example: Let’s say your net take-home pay is $3,000 per month, and your non-discretionary expenses—things you absolutely have to pay, like rent—are $2,000.
Now you’re left with $1,000. With standard budgeting, you’d factor in groceries, entertainment, clothing, etc, and—hopefully—have a small amount remaining at the end to contribute to savings. With the pay yourself first method, you’ll decide on a savings goal up front and put that amount away before you budget for anything else.
For example, say you want to save 5% of your take-home pay. That’s $150 per month based on take-home pay of $3,000. Each month you’ll set aside $150 the minute you get paid (or $75 per paycheck if you get paid twice per month.) Now after your non-discretionary expenses and your $150 savings you’re left with $850. You’ll budget all remaining spending on groceries, entertainment, etc, from the remaining $850. By prioritizing saving as a top line item in your budget you guarantee that a specific amount builds so it can earn interest and grow -- whether it’s for short-term needs, a retirement fund or some other large goal or purchase.
Start paying yourself first
The first piece of advice, above all else, is to promise yourself that you’ll pay yourself first each month indefinitely. The whole concept is to make saving as necessary as is paying your rent -- you can’t skip a month here or there. Here are some tips to get you started:
Target your personal savings goal
How much can you afford to save? In our earlier example we set a goal of 5 percent of monthly take-home pay, though many sources recommend a target of 15 percent of your monthly take-home earnings. How much can you afford to commit to?
Figure out your income and expenses
Before setting a savings goal, determine where you stand financially. List your monthly income and expenses, both fixed and fluctuating. Taking a hard look at your standing will help you set a realistic savings goal.
You may want to take advantage of one of several budgeting apps to help you calculate, like Mint, or You Need a Budget. It can be helpful to go back a few months to see if the numbers have changed—patterns can help you identify where changes need to be made.
Note: if you’re carrying high-interest debts from credit cards or other loans, and struggling just to keep up with monthly minimums, you may want to consider paying them down before you start paying yourself first. If your interest rates are high, the money you owe will accumulate faster than the the savings you put away. In this sense you can think of paying down high interest debt as a form of paying yourself first—just think of all that interest you’re saving yourself! You also may want to consider consolidating debts into a lower-interest loan to help you pay it off quicker and start building savings.
Make changes where you can
Can you reduce some of your expenses to free up more money? It could mean eating out less and brown bagging your lunch more often. You may want to cancel your cable subscription, or renegotiate your insurance rates. It could mean refinancing your student loans for a lower monthly payment, or making an effort to curb impulse shopping. It could also be taking on opportunities to earn more money.
Whatever method you take to reduce your variable expenses, make sure it frees up enough money to save consistently each month to reach your savings goal. At the same time, tweak your savings goal to fit what you can realistically afford today.
Part of what makes paying yourself first such a great financial habit is that money will definitely be getting saved away, each month, without fail.
Automate your savings
It’s been suggested that you start automating your savings before making adjustments to how much you save, it could be better to at your savings goal first to avoid overextending yourself. However, once you actually start paying yourself first, continue to make changes and tweaks as you go.
An ideal option is to open up a separate savings account, preferably one with a high-yield interest rate, and automate your deposits each month from your checking account. Setting and then forgetting about the money won’t tempt you to spend it or use it on something else. Ally’s high-yield savings account has a 1.90% APY.
You may also choose another interest-bearing account, like a Roth IRA, where your deposits are free of getting taxed. In time, you can use your earnings to invest in other savings and wealth vehicles that wouldn’t have been possible if you didn’t pay yourself first.
How you set up your savings strategy is up to you. One option is to automatically transfer your funds right on payday, or at a certain date each month. Knowing the dates helps if you need to change or cancel deposit amounts before they’ve been made.
Remember what the money is for
Once your savings plan is in motion, and you’ve committed a certain amount each month towards saving, be sure to keep track of the total amount you’ve saved up, and what it’s saved for.
So, if you know that you’re saving $100 towards an emergency fund, and after six months, you need to dip into it, you can’t withdraw more than $600 without dipping too much into your other needs. If it’s time to put a down payment on a car, and you’ve got $3,000 after 18 months of contributions, withdraw only the amount available in that fund -- even if your total savings is more.
Learn more about how much car you can afford.
Paying yourself first can pay off
You may not see the results immediately at first, even with a high interest rate. But stick with your savings, and you’ll see the benefits sooner than you think. Like a diet or fitness regimen, starting a dedicated savings effort places saving money in the forefront, not the background, builds financial discipline, and prepares you for future financial needs that may arise.
By paying yourself first, worrying about not having money will be the last thing on your mind.
Image: 401(K) 2012