If I’ve learned anything during the Covid-19 pandemic, it’s that building an emergency fund is the most important financial goal one can have.
According to Clever’s 2020 Covid financial impact survey, 21% of Americans didn’t have any emergency savings at the start of the pandemic, and 61% ran out of savings before the end of 2020.
Now, you’ve probably heard the phrase “pay yourself first”. It’s practically become the dogma of the personal finance world at this point.
It is the single most impactful piece of financial advice that I’ve learned and put into practice. It’s been one of the rare budgeting methods that are both simple and effective at boosting my savings. But what exactly does it mean to pay yourself first?
What does “pay yourself first” mean?
Pay yourself first is a budgeting method where you automatically deposit the amount you want to save and invest each month into a separate account before you take expenses into account. It is based on your take-home pay.
So, think of it like this. You have a dedicated account for saving or investing and use a second direct deposit with your employer to automatically deposit the amount you’d like to save each month. This way, you no longer have to worry about having enough left over at the end of the month to save. The amount that hits your general expenses account is the amount of income you can use for living expenses.
It is easier to consistently contribute to your saving and investing accounts when you pay yourself first. It’s almost impossible to get to the end of the month with $0 in your bank account and say, well I live paycheck to paycheck, I can’t save anything.
One thing that you should keep in mind with this method is that it doesn’t account for a lot of debt. If you’re someone with credit card debt or student loans, you can still use this method, but I recommend making a few changes.
First, if you don’t have an emergency fund I suggest you build up at least 3 months of living expenses. Then use the amount you planned to save, to pay down your debt. Once you pay off all of your debt, start saving again.
Why you should pay yourself first
The biggest reason that you should pay yourself first is that it guarantees you will save what you plan to save. You don’t need to worry about having money left over at the end of the month to save. Rather, you’re saving from the onset and spending what’s leftover.
The pay yourself first method is also simpler than other budgeting methods. It doesn’t require that you monitor and justify each expense since you’re already reaching your savings goal. If you want, you can quite literally spend whatever hits your personal account without worrying.
Depending on your goals though, this may not be the case for everyone. Especially if you have very ambitious savings goals. In this situation, you’ll likely have to use the pay yourself first method in tandem with another budgeting method like the line item method where you track each expense.
Paying yourself first can also help reduce impulse purchases. This is because you’ll have less money overall going into your account and will artificially create a sense of scarcity. For some, this can lead to more thoughtful spending. Of course, it depends on the individual though.
Most importantly, the pay your self first method gets you in the habit of prioritizing saving overspending. This habit, compounded over a lifetime is critical in building strong long-term financial health.
How to pay yourself first
I’m sure that most of you will agree that the best way to get a savings habit to stick is to make it as easy and painless as possible. Automate everything you can so you don’t have to think. The less you know it exists, the better. That’s the goal with this budgeting method.
Step 1: Set your savings goals
If you don’t have any savings goals, start by asking yourself: What do I want to save for?
A few examples could be retirement, a house, a wedding, preparing for a child, etc. Perhaps you’d like to save a certain amount each month or save enough to retire early.
Once you know what you’re saving for, write it down. It’s easier to commit to saving when you know what you’re saving for. Studies have even shown that just labeling money with a specific purpose creates a psychological barrier to spending it. The more barriers you can build between your money and spending it, the better.
My personal goal is to save 40% of my take-home pay. 20% goes toward my retirement and the other 20% toward my student loans.
Step 2: Review your income
Now that you know what you’re saving for, take a look at your income and see how much you can save toward your goals each month.
The first thing you need to do is calculate your average monthly take-home pay. Then calculate your needs-based expenses. This should include things like your rent, food, utilities, transportation, etc.
Once you have your average monthly income and your needs-based expenses, subtract the expenses from your monthly income. This is considered your discretionary income and what’s used to decide how much to save.
Now compare your discretionary income to your goals and decide how much you’d be comfortable saving. Make sure that you keep some of this aside each month for your wants. Ensuring that your life is still enjoyable is also important. Let’s run through an example.
- My goals are to save for retirement and save for a downpayment on a house in two years.
- My average monthly take-home pay is $2500.
- My rent is $800, food costs $200, my utilities are $150, my phone is $50, and my transportation costs $300. So my expenses total $1500/mo which leaves me with $1000 in discretionary income per month.
Since a house in my area costs $150,000, a 5% downpayment would be $7500. To reach this amount in two years, I’d need to save about $300 per month. So, I will save $400/mo for retirement and $300/mo for a downpayment on a house and keep $300/mo for wants.
Step 3: Set up separate accounts
The next step is to set up the appropriate accounts for your goals. This can be tricky because you’ll need to take the time horizon, or when you want to reach your goal by. A general rule of thumb is if you need the money within 5 years, keep it in a high yield savings account. If you won’t need the money for more than 5 years, open a brokerage account.
If you’re saving for retirement, first check that your employer doesn’t already offer an account. If your employer does not provide you with a 401k or an IRA, then you should set up a Roth IRA account. A couple of excellent brokers are Vanguard, Fidelity, or Charles Schwab.
In my case, my employer provides me with a 401k. So this is where I will deposit the $400 for retirement. Since I will need the money for a downpayment in 2 years, I will deposit this money into a high yield savings account.
Step 4: Automate paying yourself
Once you have the appropriate accounts set up, it’s time to automate the process. I use additional direct deposits through my employer so that part of my paycheck goes directly to 401k and part goes directly to my high yield savings account.
To do the same, you should check with your employer if you can have more than one direct deposit. If you can, set up as many as you need.
If you can’t have multiple direct deposits, you can alternatively set up automatic bank transfers through your bank. In this case, it would work like this — your regular paycheck gets deposited into your account then a portion gets automatically transferred to your other accounts.
Step 5: Repeat and don’t get discouraged
Finally, make sure that you periodically review the process and update it as your goals change.
If things don’t go smooth in the beginning, don’t get discouraged. Make small tweaks and eventually, everything will fall into place.