Paying yourself first is probably the most powerful and under utilized method to building real wealth. The idea behind it is very simple. Instead of paying all of your monthly bills and expenses and then putting the rest into savings, paying yourself first means you put some money into savings first and then pay whatever bills you have after. This method just plain works because of two main reasons. First, YOU decide how much money you want to save and then you adjust your expenses after that. It can be empowering to decide your own savings rate and it is in sharp contrast to the first method where your bills and expenses dictate how much money you set aside.
The second reason paying yourself first works is related to Financial Commandment #1. It literally forces you to live within your means because setting aside money for yourself as your first step ensures that money is not being used on something you may not need. This is a surefire way to get out of debt and build real savings and wealth. People can be very fickle creatures so the best way to make a habit out of spending less than you earn is to make it impossible to spend more in the first place.
Paying yourself first is an amazingly effective financial practice, but again humans can tend to revert back to old habits. If paying yourself first is a relatively new practice, it can be tempting after the initial excitement to cut back a little bit on your savings rate. The best way to avoid this is to pay yourself automatically. This is very easy nowadays and here a a few ways to do just that:
Online savings accounts: Most big banks will offer you a savings account in addition to their checking account. You should avoid this because the interest rates on savings accounts from big banks are usually atrociously low and more importantly, it still makes your money easy to access. Using an online savings account separate from your checking account is a much better idea because their interest rates are usually much higher (though not incredibly high as most online accounts pay around 1%), but also it creates an extra barrier against you from withdrawing that money on a whim. Some great online savings accounts include Capital One 360, Ally, and American Express.
IRA: Opening an IRA is easier than ever. You can open one if you’re employed or self-employed. I have had my Roth IRA with Vanguard for a few years now and it has been great. They allow you to automatically contribute as much as you want and as often as you want. They also have a very good selection of mutual funds which have very low fees. It takes about 5 minutes to sign up and connect your bank account. They also offer very good guidance as far as which mutual funds would be best for your situation. Of course nothing is guaranteed with stocks or mutual funds, and there are key differences between traditional and Roth IRA’s which will be a subject of later posts, but for long term growth, it’s tough to beat a monthly IRA contribution.
401k: A 401k can be a great way to automatically pay yourself. Most 401k’s allow employers to take a pre-determined, and pre-tax, amount from your paycheck and put it into your account. This is a great deal because it lowers your taxable income and since that money is automatically deducted from your paycheck, you’re not going to spend it. There are some things to watch out for in 401k plans such as higher than normal fees and the fact that you have a limited selection of funds to choose from. However, many companies offer a match on your contributions. They vary among companies, but if you contribute 5% of your paycheck and your company matches the full 5%, that’s like getting a 100% return for free. Not a bad deal at all.
These are the more popular ways to automatically pay yourself. While you can just go and change your contribution amount even if you are doing monthly contributions, this extra step makes it a little tougher to do. Automatic contributions are the best way to pay yourself first and grow your wealth.
Leave a comment below and share your favorite way to pay yourself first.