Yesterday I shared some financial tips my father gave me when I was a sophomore in college. He didn't stop there. After I graduated, he continued to offer advice. One of the things he told me was, “Pay yourself first.” To explain, he gave me a copy of George Clason's 1926 classic, The Richest Man in Babylon. I didn't read it.
In retrospect, I ought to have been a little less stubborn. It took years for me to understand what “pay yourself first” really meant, and by that time, I was already in financial trouble. If I'd read The Richest Man in Babylon when I was 21 — if I'd learned to pay myself first — I might not have had $35,000 in debt by the time I was 35.
To pay yourself first means simply this: Before you pay your bills, before you buy groceries, before you do anything else, set aside a portion of your income to save. The first bill you pay each month should be to yourself. This habit, developed early, can help a person build tremendous wealth. I wish I'd understood this when I graduated from college.
Why pay yourself first?
If you're just getting started in the Real World, saving may seem impossible. You have rent, a car payment, groceries, and maybe student loans. Sure, you'd like to save, but there's just no money left at the end of the month. And that's the problem: most people save what's left over — left over after bills and after discretionary spending.
But if you don't develop the saving habit now, there are always going to be reasons to delay: you need dental work, you want to go to Mexico with your friends, you aren't making enough to pay your bills. Here are three reasons to start saving now instead of waiting until next year (or the year after):
- When you pay yourself first, you're mentally establishing saving as a priority. You're telling yourself that you are more important than the electric company or the landlord. Building savings is a powerful motivator — it's empowering.
- Paying yourself first encourages sound financial habits. Most people spend their money in the following order: bills, fun, saving. Unsurprisingly, there's usually little left over to put in the bank. But if you bump saving to the front — saving, bills, fun — you're able to set the money aside before you rationalize reasons to spend it.
- By paying yourself first, you're building a cash buffer with real-world applications. Regular steady contributions are an excellent way to build a nest egg. You can use the money to deal with emergencies. You can use it to purchase a house. You can use it to save for retirement. Paying yourself first gives you freedom — it opens a world of opportunity.
Once I developed the habit of paying myself first, I couldn't help wishing I'd done so right out of college. I wished I had listened to my father. If I had, my spending may never have spiraled out of control.
How to pay yourself first
The best way to develop a saving a habit is to make the process as painless as possible. Make it automatic. Make it invisible. If you arrange to have the money taken from your paycheck before you receive it, you'll never know it's missing.
Part of your savings plan will probably include retirement, but you should also save for intermediate goals too, such as buying a house, paying for a honeymoon, or purchasing a new car. Here are three easy ways to begin doing this yourself:
- If your employer offers a retirement plan — such as a 401(k) or 457(b) account — enroll as soon as possible, especially if the company matches your contributions. Matched contributions are like free money.
- Starting a Roth IRA is one of the smartest moves a young adult can make. These accounts allow your investments to grow tax-free. Because of the extraordinary power of compound interest (and compound returns), regular investments in a Roth IRA from an early age can lead to enormous future wealth.
- Open a high interest savings account at a bank like ING Direct or FNBO Direct. Set up automatic transfers into this account, either directly from your paycheck or from your regular bank account. Treat these transfers like you'd treat any other financial obligation. This should be your first and most important bill every month.
The real barrier to developing this habit is finding money to save. Many people believe it's impossible. But almost everyone can save at least 1% of their income. That's only one penny out of every dollar. Some will argue that saving this little is meaningless. But if a skeptic will try to save just 1% of his income, he'll usually discover the process is painless. Maybe next he'll try to save 3%. Or 5%. As his saving rate increases, so his nest egg will grow.
My wife is a perfect case study. She started by having 8% of her pre-tax income set aside in her employer's retirement plan. As her salary increased, she increased the amount she saved, routing it to various retirement accounts. Because she never saw the money in her paycheck, she never missed it. Now she saves 24% of her income, and she receives a 6% employer match! How did she do this? By paying herself first.
Young adults should make it a priority to develop a regular saving plan. Establishing this habit early can lead to increased financial security later in life. But even those of us who got a late start should do our best to pay ourselves first. I didn't begin doing this until just a couple years ago. Better late than never.
Though many personal finance books briefly explore the idea of paying yourself first, David Bach's 2003 best-seller, The Automatic Millionaire is devoted exclusively to the subject. The entire book is a step-by-step guide to developing the saving habit and making it automatic. If you'd like more ideas about how to make this work in your life, this is the place to look. Any good public library will have a copy.