If you have been around the personal finance realm for some time, you might have heard the phrase ‘pay yourself first’ being tossed around.
But what does 'pay yourself first' mean?
Paying yourself first is a pillar of personal finance that if practiced consistently over time, can lead to incredible financial health.
It is all about prioritizing your savings to safeguard your financial future as opposed to prioritizing all your spending then saving what is left over.
Paying yourself first nurtures a sense of self-discipline that will focus your efforts on your financial goals and propel you through the stages of financial freedom to financial abundance.
Want to learn how the pay yourself first budget works? Well, let's jump right in!
Related: The 7 stages of financial freedom
What does it mean to Pay Yourself First?
The Pay Yourself First budget is quite fascinating.
Unlike other budgeting methods, this reverse budget is designed to help you build up your savings or investments before immediate expenses. It favors increased and consistent savings over time.
Related: What are the main budgeting methods?
Here's the thing: Reverse budgeting is the opposite of most budget methods where you subtract your expenses from your monthly income.
Here, you focus on your saving goals such as retirement savings or emergency fund, then as long as you meet your monthly savings goal, you can use the rest for bills and other costs. This way you don’t have to crunch every single number.
The National Study of Millionaires found that three out of four millionaires said that regular, consistent saving and investing over a long period of time was the reason for their success.
“Successful investors typically build wealth systematically through regular investments, such as payroll deductions at work or automatic deductions from a checking or savings account,” says Jess Emery, a spokesperson for Vanguard Funds.
How To Pay Yourself First
1. Calculate your monthly after-tax income
Factor all sources of income from your full-time job, side hustle, and even dividends. Write down this number.
2. Determine your monthly savings allocation
A good place to start in determining your savings allocations - that is, how much you should pay yourself - could be the 50/30/20 rule. The rule involves dividing your after-tax income into 3 distinct buckets to help you prioritize your monthly financial commitments:
- 50% to needs and essentials such as housing and food
- 30% to wants such as travel and cocktails
- 20% to savings and debt repayment (aka pay yourself first)
List all your essential and non-essential expenses, re-evaluate and balance them out to come to a good savings rate for yourself. The goal is to make changes to your spending budget to allow the spending vs savings allocations to align with your income. The minimum savings goal to aim for is 20% of your after-tax income.
Keep in mind that this is your budget - these allocations aren’t set in stone. You can make the percentage breakouts work for your unique financial situation. It can be a 50/20/30 breakout, a 45/10/45 breakout, 30/30/40 breakout. The point is to make the savings goal work for you and for your financial future.
Related: What is the 50/30/20 rule budget and is it right for me?
3. Re-adjust your goals
At the core of paying yourself first is consistent and increased savings over time. As your financial situation changes, say you receive a promotion at work, you have some side hustle money coming in, or you reduced your eating out spending (oh yea!), etc, adjust your savings goal to reflect the changes. The goal is to keep increasing the amount that you pay yourself over time on your road to financial freedom!
Tips to start paying yourself first today
1. Automate your savings (and investments)
Automating finances is one of the best and most effective money-managing practices.
So what's the secret behind it?
Automating savings and investments takes away emotions (and oh, there can be so many emotions when it comes to money) so it is easy to incorporate into your current financial strategy.
And get this: Automating your finances is particularly effective when working towards a savings goal, managing recurring bills, and in your debt payoff strategy. This has to be one of my favorite ways to save towards a financial goal!
2. Contribute to retirement accounts as much as possible
News flash: Retirement accounts are built to incentivize us to contribute to them, so they are innately quite beneficial to us.
For example, many companies match 50% to 100% of employees’ 401(k) contributions up to a certain percentage of their salary as part of their employee benefits package. This is quite simply free money that you shouldn’t be leaving at the table.
A National Study of Millionaires found that 80% of net-worth millionaires in the study said that investing in their employer-sponsored retirement plan was the main way they reached millionaire status.
You can let that simmer for a moment - I know I had to.
What’s more, retirement accounts allow you to defer paying income taxes on the money you save for retirement, allowing you to have more money in the account, and consequently, more growth as a result of compounding interest.
What more could you ask for? Really.
Related: How compound interest can work for you
3. Separate your savings account from your everyday checking account
Keeping your savings separate from your spending accounts is a great way to ensure that you actually follow through with paying yourself first. It would be pointless to make savings contributions only to use up your savings as the month progresses.
4. Prioritize your debt pay-off
If you have a debt, you're not alone. The average debt balance in the U.S. in 2020 was a whopping $92,727!
Simply put, debt can be a major liability for your finances. If you are in debt, a budget can help you plan a debt payoff strategy, without which you might find yourself in constant financial struggle.
Even if you are thinking about saving and investing, you need to ensure that you are in good shape before you start. If you have a credit card debt, with the average credit card interest currently at 16.12%, the debt will likely drain your resources because no investment will consistently outperform such a high APR.
It is absolutely normal for us to prioritize paying off our bills and debt, but when it comes to our long-term savings goals, we can often take a back seat. It is time to be more intentional with our financial goals and prioritize them if we have any intentions to be financially independent. You can start by paying yourself first today.