Millions of well-intentioned people around the world try to save and invest money every month but fail. They are consistently unable to hit their financial goals and their savings targets. As a result, they give up and decide to continue living a financially undisciplined life. Financial planners have observed many such cases and then they finally came up with the “pay yourself first” principle. The “pay yourself first” principle is a simple yet revolutionary method that has helped millions of people around the world save and invest large sums of money.
In this article, we will have a closer look at the “pay yourself first” principle is and why it provides better results.
What is the “Pay Yourself Principle”?
The “Pay Yourself Principle” is a method of prioritizing your monthly spending which puts your savings first. Hence, you need to fund your savings and investment accounts before you pay any other bills. The sequence in which bills are paid might seem irrelevant if we consider a purely mathematical point of view. However, up until now, we have realized that personal finance is more about behavior and less about mathematics.
For example, if a person has a $100 income, they usually split their expenses in the following manner. They may set aside a percentage for mandatory expenses (let’s say 50%), then they will set aside money for discretionary expenses (let’s say 25%), and then at the end of the month, they plan to fund their savings accounts with the leftover money (25% in this case). The “pay yourself first” suggests that the sequence be changed. Instead of putting money away at the end of the month, it should be put away at the beginning of the month. Hence, in this case, as soon as the person gets their income, they should first fund the 25% towards savings and only then manage their expenses with the balance 75%!
Why Does the “Pay Yourself First” Principle Work?
The “pay yourself first” is a behavioral tool using which we give our savings first priority over any other expenses in our life.
We treat the savings expenses as an outside bill that needs to be paid to a third party, just like rent, mortgage, or a student loan payment. It is important to think of savings in that manner. This is because if we try to save after all expenses are paid up, we tend to increase our expenses and not save at all.
After all, there is no limit to increasing your discretionary expenses. You can always eat out more often, or go for that vacation or buy that latest car. There is no end in sight for the discretionary expenses and some of these companies are so good at marketing, that they end up convincing us that some of these momentary pleasures are more examples than our long term well-being.
The “pay yourself first” enforces discipline. If there is no money left over for discretionary expenses at the end of the month, then a person will be forced to cut down those expenses. It is important to understand that the sequence of payments is not just about the time when the bills are paid. More importantly, the sequencing of payments shows the priority that we attach to these payments.
How to Implement the Pay Yourself First Principle?
There are certain rules which need to be followed in order to effectively utilize the pay yourself first principle. Some of these rules have been mentioned below:
- Automate Your Savings: In order to treat your savings accounts like external bills, we need to set up the system to pay them up like external bills. For our mortgage accounts and our monthly payments, we generally give the bank authority to make automatic deductions to our bank accounts. This is what needs to be done for our investment accounts as well.
We must decide on the dollar amount we need to save every month, then we need to enroll with financial products such as systematic investment plans to ensure that the amount is auto-deducted from our bank each month. This system works best if you have an emergency fund for expenses that may suddenly arise. The emergency fund helps to keep the proportion of your monthly budget unchanged.
- Select the Right Vehicle for Investments: It is important to select a long term and high yielding investment vehicles for the money that is being deducted. If we keep the investment money lying around in savings accounts, then inflation will eat away a part of our savings.
There are different kinds of investment vehicles that have been created for different purposes such as retirement, kids’ education, etc. We have discussed these vehicles in different articles. It is important to channel your savings correctly into these vehicles.
- Avoid Using Credit Cards: Lastly, the whole concept of “pay yourself first” rests on the assumption that once you take out money for savings from your income, there will only be a finite amount of money left for expenditure. However, if you start using credit cards, then this may not be the case. Since you are not spending from your income but instead borrowing money to do so, credit cards end up breaking the discipline. The investor will not realize that they are running over their monthly budget. Instead, they will keep accumulating debt which will eat into their savings budget every month.
The bottom line is that “pay yourself first” may seem quite simple at first. However, it is a powerful principle. There are many people who saved millions of dollars by consistently applying this principle over the years.
