Financial books and blogs frequently tout the importance of paying yourself first. And in many cases, this may well be the best course of action. Certainly when you’re new to personal finance and trying to get your affairs in order, if you don’t follow this wise advice you may never get around to saving. But the practices that serve us well when we are first starting out can hold us back later on when we are wiser and better off financially.
The cost of paying yourself first only begins appearing when your income begins to exceed your expenses by a noticeable amount. Let’s play with some numbers to see how this breaks down.
Pay yourself first:
Let’s say your net monthly income (that is, after taxes) is $1400 a month. Rent and other bills cost you $1000, leaving you with $400 for living expenses (such as groceries) and entertainment (dinners out, movies, bars, video games, whatever) for the month. That’s $100/week, and when a dinner out with your partner can easily run you $40, that money runs out quickly. It’s easy to see how it might be difficult to carve out a percentage of your budget for savings in this scenario. Paying yourself first makes sense here, because if you don’t, you may have nothing left to save later. Decide how much you can spare and set it aside FIRST, before you spend it.
Don’t pay yourself first:
If, however, your gross income is $3000 a month (net $2000), things are a little different. Let’s say you’ve developed a good habit of paying yourself first, so you squirrel away $200 (10% of your net) before paying anything else. Your bills still total $1000, so you now have $800 left over for living expenses and entertainment! Here’s where things go off-course: you’d probably be perfectly comfortable with only $600, but if $800 is just sitting there tempting you, you’re much more likely to spend it all — impulse buys, little splurges, things you don’t want or need. You’ll spend it, but you won’t really get much benefit from having done so — especially compared to the value of the compound interest you could have been earning on it.
In this latter case, paying yourself first is precisely backwards. There’s a much better way to budget your $2000: pay yourself LAST! You know that you have $1000 of bills which have to be paid one way or another. And through experience you’ve learned that $600/month in living money is a comfortable lifestyle. So you budget those two figures and route the money to two separate checking accounts — $1000 goes to an account for bills which is accessible only by checks (which you leave at home when you go out) or electronic bill pay, and $600 goes into an account which is also accessible via your ATM/debit card. Now, after setting aside in advance the money you need to keep your bills paid and live a comfortable life, whatever’s left over goes to savings — $400, DOUBLE what you would have saved if you’d paid yourself first.
This strategy becomes even more valuable if your income fluctuates a bit — let’s say the following month you work some overtime and wind up with an extra $200 net — if you paid yourself first, this money is likely to get frittered away, but by paying yourself last, you get to keep it instead of giving it to people for things you don’t really need or, let’s face it, want. This month you save $600 instead of $400 — excellent!
Some people call “pay yourself first” the golden rule of personal finance — but it is by no means the only way, or even the best way, to save successfully. I’ve been paying myself last for several years, keeping just the leftovers after allocating fixed amounts each paycheck to bills and to discretionary spending. By doing so, I’ve seen my net worth consistently grow over that time, putting my leftovers into paying down credit cards as quickly as possible (until I learned how to profit from keeping card debt), saving in high-interest savings accounts, and buying CDs to maximize my returns on my investment. Paying myself last has improved my net worth a great deal, much more than if I’d been paying myself first. The key is not to follow anyone’s financial advice (even if it’s EVERYONE’S financial advice) without question, but to think about what will work best for you, try things, and keep the practices that make you successful.