When you get your paycheck, who do you pay first? The bank for your mortgage? The gas and utilities company? The taxman? If you're like most people, you pay all of the debts that you need to pay first, spend a little on luxuries and wants, then save whatever is left. Most people, however, aren't rich. The median American net worth at 50 years old is 4,200. Depending on where you live, $124,000 might not even be enough for a down payment on a house. This is where “most people” end up by taking this path.
The problem with this approach is that you prioritize giving away your money. Everyone else gets their hands on your hard-earned dollar before you get anything. By paying other people first and yourself last, you are guaranteeing a mediocre financial situation for yourself.
How is there any other way of doing things? Simple: pay yourself first. Just reverse the order of who gets the money and you will see tremendous wealth built over the long term.
What is Paying Yourself First?
When I say “pay yourself first”, I don't mean to go out and buy a new purse or to buy new shoes as soon as you get your paycheck. What I mean is to take a portion (10%-20%) of that paycheck and put it away into savings/investing… BEFORE you do anything else with the money. So basically, setting aside money for your future FIRST.
What this means is that if you receive a bi-weekly paycheck of $2000, you will take $200-$400 and transfer it from your checking account to your savings/investing account every two weeks. You won't go and pay for the gas in your car first. You won't go and pay your rent to the landlord first. You won't go and pay for your Netflix subscription first. You will pay yourself first by putting away money for your future.
There are two ways of doing this. You can do it manually or automatically. Manually is exactly what it sounds like: every time you see a deposit into your bank account from your job, you transfer a set amount to your savings account or brokerage account. This is great, but few people actually have the discipline to do this. Automatically paying yourself first is the best because the bank does it for you and you never even have to see the money. Setting it up is easy and a great way to build wealth invisibly. You barely have to work it into your monthly budget. We'll get into how to do/setup both methods later in the post, but first, what is the importance of paying yourself first?
Why Pay Yourself First?
You might be thinking to yourself: “How is this any different than just saving some money AFTER I pay my bills and stuff?” or “How can such a simple trick make that big of a difference?” The answer: basic human psychology.
Let's say you have a job that pays you $40,000 every year. With a 40k salary, this means your bi-weekly checks should be in amounts of around $1500. Let's also assume that your rent is $500 bi-weekly, food is $200, gas is $100, and internet/cable is $100.
What Happens When You Don't Pay Yourself First
If you don't pay yourself first, this is likely to happen. You get your check of $1500 and immediately pay off “urgent” expenses: $500 goes to the landlord and another $100 goes toward internet and cable. Your balance is $1500 – $600 = $900. Then you buy your groceries which total $200 and your balance becomes $700. Finally you're going to pay for gas to refuel your car which costs $100. Now your balance is at $600. Your “mandatory expenses” are paid, but…
Throughout the week, you get invited to the bar a few times and spend $300 on “a good time.” You also see a really nice pair of shoes at the mall which cost $150. Seems pricey, but you check your banking app and it says you have $300, so you buy the shoes. Also, your friends invite you out to a few dinners and you feel obliged to go so spend $130 on dine-ins throughout the week. You then remember reading this blog post and think: “oh shit, I should save some money for my future”, so you check your bank account and come face to face with a whopping balance of $20. “Ahh that's not enough to save. It's fine: I'll save next week when I have more money.”
What Happens When You Pay Yourself First
If you DO decide to pay yourself first, you'll find that you won't even notice it. You get your check of $1500 and (whether manually or automatically) $200 goes directly into your savings/brokerage account. With the remaining $1300, you pay off all your “mandatory expenses” and are left with $1300 – $500 (rent) – $200 (food) – $100 (gas) – $100 (internet) = $400.
Throughout the week, you still go to the bar and have “a good time,” and spend $300. When you go out to eat with your friends, however, you look at your balance of $100 and spend only $50 on food, saving the rest for grocery shopping. Now when you go to the mall shoe shopping, you don't buy the $150 pair of shoes because you can't afford it; you settle for a $50 pair of shoes. Setting aside money first doesn't even affect you and you'll realize that you earn enough money to both enjoy life and save for your future.
There hasn't been a dramatic lifestyle change, yet that money you put away by paying yourself first will do wonders for your financial situation. What's more, if you DO decide to live below your means, you'll accelerate your wealth-building even more!
How Human Brains Work
“Losses loom larger than gains” (Kahneman & Tversky, 1979). This idea is that people gain more unhappiness about losing something than they gain happiness from acquiring the exact same thing. This is the reason why paying yourself first works.
For example, if someone gave you a brand new laptop, you would probably feel happy. But if you dropped your own laptop and permanently broke it, you would feel twice as unhappy. Similarly, the psychological pain of losing $50 outweighs the pleasure of making $50. Crazy, but that's just how human brains work.
A big red negative number in the bank account is an easy way for humans to recognize a “loss”. So for most people, it's a lot easier to spend $20 when their balance is at $100 because their balance is only reduced to $80. It's a lot harder to spend $20 if their balance is $10 because the balance would then show -$10 which registers as a loss in the human brain.
This is why after paying yourself first, you won't be inclined to spend the same amount as when you didn't pay yourself first. If you did, your bank balance would show a negative loss. And your brain hates losses.
The Magic of Compounding
Let's say you started working at 25 and started paying yourself first immediately. You have a job that pays 40k and every two weeks you put away 13% of your income ($200). You choose to invest this money into the stock market, which has a historical return of 10% every year. But let's assume a conservative 7% annual return. By the time you're 65, paying yourself first will have yielded you a total of $1,139,202.94. That's over a million dollars… in cash!
Not only that, but this scenario assumes that throughout your 40-year-long working life, you got no raises, no bonuses, made just above the median income level, AND the stock market did worse than its track record.
If you make an average of 60k per year over your working life, contribute at the same rate, and the stock market does exactly as it has over the last 100 years… you'll retire with $3,615,456.68. Almost 4 million dollars! That'll go a long way toward your retirement lifestyle.
Yet the median amount of money in an American's retirement account at 65 years old is $120,000. Barely enough to live off of for a few years. Why? Because most people don't pay themselves first.
The Magic of Tax-Deferral
As if paying yourself first couldn't get any better, there is a cherry on top: you could save lots of money in taxes.
If you're in Canada, you can open up accounts such as a TFSA (tax-free savings account) and an RRSP which basically allows for you to pay close to no tax on your savings. If you're in the USA, sorry no such luck….. Just kidding, America offers a very similar account called an IRA or Roth IRA that basically does the same thing.
For every single dollar that you make, you need to pay tax on it. Depending on how large your income is, you could pay up to 45% of your salary toward taxes. That's almost half your money that you don't get to keep!
By using tax-free savings accounts and tax-deferral accounts, you can save almost ALL of that tax money. This means that if you pay yourself first into these types of accounts, you are not only employing compounding interest but also saving yourself anywhere from 10-50 cents on the dollar. Tax-deferral is yet another reason why paying yourself first pays off.
What if I Literally Can't Afford It
Here's the only hard part about paying yourself first. On some difficult months, you might find that you come up short on funds to pay your “mandatory” expenses and find saving money hard. If this ever happens (and it won't if you plan well) you'll have to hustle.
You might be tempted to take the easy route out and withdraw from your savings account or liquidate some of your investments, but that is a terrible thing to do. You might think that it's just this once. Or that it'll never happen again. Or this is an emergency. But by withdrawing from these accounts, you are subconsciously training yourself that it's okay to take money out from your savings. That defeats the entire point of savings in the first place.
The better, but more difficult alternative is to hustle. Find ways to make the money necessary to pay off your expenses. Give private tutoring lessons. Sign up for Uber and drive a few nights. Babysit your neighbors kids. Cut some lawns. Freelance write for a publisher. Put your ego aside and do the tasks necessary for you to build your financial future.
Instead of letting your creditors and loaners limit you, let them motivate you to make more money. (Also it might be a good idea to set up an emergency savings account).
How to Automatically Pay Yourself First
As mentioned above, paying yourself first isn't easy to do manually. It requires discipline and a tough savings plan to transfer away 10% of your income every month into an account you won't have access to for a long time. Luckily, you don't have to. With the online banking of today, it's easier than ever to automate paying yourself first.
I bank with TD but these steps should apply to most if not all banks:
- Open up your online banking (by phone or by computer)
- Find the place where you can transfer money (for TD it is literally called “transfers”)
- Click on “pre-authorized transfer service” or anything similar
- Select the frequency to be however often you get a paycheck
- Select the start date to be the date of your next paycheck
- Select an amount of money that is proportionate to your income (at least 10%)
- Select the account you want to transfer money to (TFSA, savings, or brokerage)
- Click next and confirm it
That's it! You've now automated paying yourself first. No need to build crazy savings habits. If you weren't able to follow the above steps, you can always call your bank and ask “can I set up pre-authorized transfers?” Or just ask “how can I set something up to pay myself first?”
Get Out There and Start Building Wealth
Paying yourself first is undoubtedly one of the most powerful and easy ways to build long-term wealth. Some people choose to take it a step further and pay themselves first by investing in more intricate investment vehicles, but fundamentally, all wealthy people have good money habits and pay themselves first.
Out of all the money management tips, paying yourself first is the most important one. And you don't need to be a certified financial planner to implement it. So what are you waiting for? Get out there, start saving, and start building your financial future. I promise that your future self will thank you for it!
Thanks for reading through my post! I hope you gained something useful from it that will help with your financial goals and/or had fun reading it. For more about achieving financial freedom, head over to this post. To gain some insight into whether you should take the money you paid yourself and buy stocks or ETFs, check out this post here. For more about me, head over to this link here. Finally, for exclusive updates and newsletters, drop your email in the “get updates” box up top! Let me know your thoughts and suggestions in the comments!
Jeff is a current Harvard student and author of the blog Financial Pupil who is passionate about learning, living, and sharing all things personal finance-related. He has experience working in the financial industry and enjoys the pursuit of financial freedom. Outside of blogging, he loves to cook, read, and golf in his spare time.