How to Pay Yourself First
How to Pay Yourself First
The phrase "pay yourself first" has become increasingly popular in personal finance and investing circles. Instead of paying all your bills and expenses first and then saving whatever is left over, do the opposite. Set aside money for investing, retirement, college, a down payment, or whatever requires a long-term effort, and then take care of everything else.
Steps

Determining Your Current Spending

Determine your monthly income. Before paying yourself first, you need to figure out how much to pay yourself. Determining this begins with taking a look at your current monthly income. To determine monthly income, simply add together all your income sources for the month. Note that this a net amount or take-home income after deductions from paycheck or applicable taxes. If you have an income that fluctuates from month to month, use your average income over the past six months, or a number slightly below average to represent your monthly income. It is always better to choose a lower number, that way you're more likely to end up with more income then planned, rather than less.

Determine your monthly expenses. The easiest way to determine monthly spending is to simply look at your banking records for the past month. Simply add together any bill payments, cash withdrawals, or money transfers. Be sure to include any cash payments you received that were spent as well. There are two basic types of expenses to be aware of — fixed expenses, and variable expenses. Your fixed expenses stay the same month-to-month and typically include things like rent, utilities, phone/internet, debt repayments or insurance. Variable expenses change month-to-month and may include food, entertainment, gasoline, or miscellaneous purchases. If tracking your expenses manually is too challenging, consider using software like Quicken or Mint. With these tools, you simply sync your bank accounts with the software, and the software will track your spending for you, by category. This gives you a clear, organized, and up-to-date vision of your spending.

Subtract your monthly income from your monthly expenses. Subtracting monthly income from expenses lets you know how much leftover money you have at the end of each month. This is important to know, since it can help you to determine how much to pay yourself first. You would not want to pay yourself first and then discover you are lacking money for important fixed expenses. If your monthly income is $2,000 per month, and your total expenses are $1,600, you technically have $400 to pay yourself first with. This gives you a good baseline idea of how much you may be able to save each month. Note this number can potentially be much higher. Once you know the current amount of leftover money you have, you can take steps to reduce expenses to make this figure even higher. If you are negative at the end of the month, reducing expenses will become even more important.

Creating a Budget Based on Lower Expenses

Look to reduce your fixed expenses. Fixed expenses may be fixed, but that does not mean you can't replace them with lower fixed expenses. Take a look at each type of fixed expense and examine if there any ways to reduce them. For example, your cell phone bill may be fixed every month, but is it possible to drop down to a plan with lower data to save money? Similarly, your rent may also be fixed, but if your rent takes up more than half of your income, you should examine perhaps downgrading from a two bedroom to a one bedroom apartment if possible, or relocating to a more affordable area. If you have car insurance, be sure to contact your broker each year to see if there are better deals available, or alternatively, continually shop around for better deals. If you have high levels of expensive credit card debt, consider a debt consolidation loan to reduce your fixed interest expense each month. This will allow you to pay off your credit card debt with a lower interest rate consolidation loan.

Look to reduce your variable expenses. This is where most savings can be found. Take a close look at your expenses each month and see where your spending that is not towards fixed expenses goes. Look at small expenses that add up over time like coffee purchases, eating out, grocery bills, gasoline, or leisure purchases. When looking to reduce these expenses, think about what you want, versus what you need. Look to cut out as many wants as possible. For example, you may need to have lunch every day at work, but purchasing lunch at the cafeteria is a want. You could select the more affordable option of making a lunch each day. The key is to look at variable expense areas that take up a large portion of your budget. Is most of your extra spending on gasoline, food, entertainment, or impulse purchases? You could target reductions in those areas by using more public transport, packing more lunches for work, opting for more affordable entertainment choices, or leaving your credit card at home to reduce impulse spending, for example. Do an online search to find innovative ways to reduce your variable expenses in areas you struggle with.

Calculate how much money you have leftover after making reductions. If you have identified a few areas to reduce your spending, subtract that amount from your expenses. You can then subtract the new expense amount from your monthly income to determine how much you have left over. Assume monthly income is $2,000, and your expenses were $1,600. After looking for expense reductions, you may have managed to find $200 in savings each month, bringing your monthly expenses down to $1,400. You now have $600 left over each month.

Paying Yourself First

Decide how much to pay yourself. Now that you know how much you have left over, you can decide how much to pay yourself. Experts recommend differing amounts. In the famous personal finance book The Wealthy Barber, the author David Chilton recommends paying yourself 10% of your net or take-home income. Other experts recommend anywhere between 1% and 5%.. The best solution is to pay yourself as much as you can based on your leftover amount each month. For example, if you have $600 left over at the end of the month, and your income is $2,000, you would be able to save up to 30% of your income. (You may only want to put 20% of that in savings, leaving yourself a little wiggle room for unexpected treats or expenses.)

Set a savings goal. Once you know how much you can possibly pay yourself, try to set a goal for a savings amount. For example, your goal may be retirement, education savings, or a house down-payment. Determine the cost of your goal, and divide that by the amount you can pay yourself monthly to determine how long it will take to attain in months. For example, you may want to save for a $50,000 home down payment. If you have $600 left over every month and choose to save $300 of that, it would take you a very long 13 years to save $50,000. In that case, you could boost your savings amount to $600 to drop the time in half (since you have $600 left over). Keep in mind that if you invest your money in a high interest savings account, or in other types of investments, the return you get would further shorten your time. To figure out how fast your saving amount will grow at a certain rate of return (say 2% per year), go online and search "Compound Interest Calculator."

Create an account that is separate from all your other accounts. This account should be only for a specified goal, usually saving or investing. If possible, choose an account with a higher interest rate — usually these types of accounts limit how often you can withdraw money, which is a good thing because you're not going to be pulling money out of it, anyway. Consider opening a high interest savings account. Many institutions offer these, and they typically pay rates that are well above a checking account. You can also consider opening a Roth IRA for your savings. Roth IRA's allow your wealth to grow tax-free over time. Within a Roth IRA, you can purchase stocks, mutual funds, bonds, or exchange traded funds, and these products all offer the opportunity to earn a higher return than a high interest savings account. Other options include traditional IRAs or a 401(k).

Put that money into the account as soon as it is available. If you have direct deposit, have a portion of each paycheck automatically deposited into the separate account. You can also set up an automatic monthly or weekly transfer from your main, active account to your separate account, if you can keep track of your balance enough to avoid overdraft fees. The point is to do this before you spend money on anything else, including bills and rent.

Leave the money alone. Don't touch it. Don't pull money out of it. You should have a separate emergency fund for just that — emergencies. Typically that fund should be enough to cover you for three to six months. Do not confuse an emergency fund with a saving or investing fund. If you find that you don't have enough money to pay your bills, look for other ways to make money or cut expenses. Don't charge them on your credit card (see Warnings below).

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