If you know something about personal finance, you understand how complicated it can be to make sure all bills are paid on time, you are fully insured, and your credit is healthy.
Juggling all the different aspects of finances usually means savings and investing takes a back seat to everything else on your plate. This is one of the reasons why so few people under 35 have any real savings. Luckily, there is one easy technique you can use to make sure your savings are always growing, called Pay Yourself First.
Savings First, Bills Later
Most people start the month by paying off all their bills, budgeting some cash for having fun or buying something extra, and finish by setting aside the rest for savings. With the Pay Yourself First model, the ordering is flipped.
Start every paycheck by taking out the savings and applying it directly to your savings or investing account. Most banks have account types that will do this though automatic transfers – this is one service you should take advantage of.
Once your savings is taken care of, just divide the remaining cash to your bills and leisure. This is a “no excuses” savings approach: no matter what, you are “paying yourself” by contributing to your savings, ensuring a steady growth rate.
Pay Yourself First in Action
Here is how it works:
- Set up automatic transfers from your checking account to savings account every month, ideally just a day or two after you normally get your paycheck. This is “Paying Yourself”.
- Pay your rent, credit cards, and any other bills for the month.
- The remaining cash is “free”. Use this for going out with friends, buying something you want, or contributing even more to your savings.
Why This Is Important
You already know the importance of having a well-developed budget or savings plan. The downside is that these require constant vigilance. You should regularly be using your receipts and account reconciliations to update your spending plan to match your actual spending. In the real world, very few people keep this up for more than a few months (even with the best intentions).
By always setting aside your savings before any other expenses, you will ensure that it will be growing, regardless of what happens to anything else. This is the most effective way to save, since it means you cannot “cheat”.
Do I Still Need a Budget?
Using a “Pay Yourself First” savings strategy is not a replacement for maintaining an up-to-date budget or savings plan, but it will make the process much easier.
Without this strategy, your budget or savings plan has a very heavy load. It needs to account for your income, keep an itemized list of your bills, budget out your food and groceries, and finally see how much is left over for savings.
Using this strategy, you are making your budget lighter and easier to follow. You no longer need to worry about savings – this is done automatically before your budget comes into play. Simply knowing that you are building a large savings cushion in case of a Spending Shock, like car repairs, lifts a ton of stress from your shoulders.
Best of all, since you know that your savings is already accounted for every month, your leisure spending will be guilt-free (so long as you use cash and avoid too many purchases on credit). Your budget or savings plan is transformed from a “task master” dictating what you can and cannot do each month to a partner. Updating your budget will be easier, since your objective changes to trying to increase the amount of your automatic transfers (and speeding up your savings), instead of balancing everything all at once.
Pay Yourself First with Tight Cash
This all makes sense if you are already balanced, but what about if you are running behind on your bills?
With a Pay Yourself First savings strategy, your savings always comes first. This means dipping into savings is almost entirely off-limits. By following this strategy, you would rather pay a bill a month late than take money from your savings to pay it off.
This is also why the strategy works. The amount you save each month is entirely off-limits for any other type of spending, unless you are getting severely behind on payments with no other option.
Building this mentality is important. Everyone “wants” to save, but the reason why so many people have so little money set aside is because savings accounts just become another source of spending money. People want to avoid credit card debt. If there is something they want to buy, they know it might be irresponsible to pay for it entirely with credit. Instead, they just dip into savings, since that money is already “theirs”, not a loan.
This is dangerous thinking because withdrawing from your savings very much is a loan. You are borrowing money from your future self (whether your future self is saving for a car, house, or retirement). Unlike a credit card, you are unlikely to pay back this loan to yourself. This means it really is just damaging your long-term wealth. By adopting a Pay Yourself First strategy, it equalizes your spending decision. If you really want to buy something today, use your credit card. If you do not want to incur the finance and interest charges from the loan, then re-evaluate if the purchase is really worth it!
Making Pay Yourself First Work
One way to make Pay Yourself First work is by keeping less of your savings as cash, which helps prevent withdrawing unless it can be avoided.
One of the best ways to do this is by dedicating a high percentage of your savings into investments like stocks, bonds, and mutual funds instead of simply sitting in your savings account. By moving your savings into investments, you kill two birds with one stone.
Less Liquid Savings
A “Liquid Asset” is something that can be quickly and easily converted into cash and spent. Savings accounts are extremely liquid assets, which is why some people have a hard time building them: cash can be spent. By dedicating a large percentage of your savings account directly to investments like stocks, bonds, ETFs, and mutual funds, it adds an extra “step” before the cash can be spent. Since you will need to sell off your assets in order to spend the cash, you are less likely to do so unless the spending is extremely important.
Making Money Work
The other advantage is that invested money will, on average, grow much faster than money in a savings account. Instead of a percentage or two of annual interest, you could see 8-10% returns by investing in wide indices or diversified mutual funds. This will help your savings grow much more effectively.
Skin in the Game
The last advantage of putting a large amount of your savings directly into investments is because it triggers the same response in your brain as if you spent the money. If you buy a stock, your mind sees it as “spent” money, which helps curb other types of spending. As your investment portfolio grows, it gets more exciting and you will be paying closer attention to how your money works for you, encouraging even more savings and investing. Over time, this helps build a big nest-egg of wealth you may have otherwise simply spent.
When Should I Use My Savings?
A “Pay Yourself First” strategy encourages withdraws from your savings account as infrequently as possible.
When To Withdraw
- Investing in a physical asset, like buying property or a vehicle
- Investing in a paper asset, like stocks, bonds, or mutual funds
- Starting a business
- Paying off big debts, like student loans or a mortgage
When Not to Withdraw
- Purchases you “deserve”, but you do not have cash for
- “Spending Shocks” that it will take less than 3 months to pay off without impacting your savings
- Holiday and Birthday gifts (this should be part of your normal Spending Plan or Budget)