Of all of the personal finance and investing techniques ever developed, one of them stands above the others in terms of making it easier to save money, and that is the strategy known as pay yourself first. While it sounds too simple to work, perhaps even trite, the pay yourself method has proven roots in behavioral economics and can make an extraordinary difference in the amount of ultimate net worth you accumulate for yourself and your family as that surplus cash quickly builds into funds you can use to invest in stocks, invest in bonds, build a portfolio of index funds, or even begin accumulating cash generating real estate properties.
The pay yourself first technique is all but effortless to implement, usually costs nothing, and you can begin it with minimal planning.
What Is the Pay Yourself First Method of Saving Money?
Pay yourself first requires you to treat your savings or investing accounts as bills that have to be paid before any of your other bills can be paid. In the best-designed setups, the money gets transferred automatically so it requires no willpower, withheld at the source, such as in the case of enrolling in a 401(k) plan, or automatically deducted from your bank account. Depending upon the type of program you’ve created, the funds are either piled up in cash, perhaps in a savings account, or used to grow your ownership of assets that generate passive income.
Why Does the Pay Yourself First Method of Saving Money Work?
Pay yourself first is based upon the fact that money, like water, expands to fill the container in which it is placed.
If you lack an objective set of financial goals for your life and you are like millions of Americans, you probably reach the end of each month and find yourself broke. You vow that next month will be different but it never is, even when you get overtime at a job, pick up extra work, or receive some sort of windfall.
No matter how much cash tumbles into your coffers, it never seems to stick around for long.
With few exceptions, such as a medial emergency, a parallel can be found in classical literature. As Shakespeare’s Cassius lamented to his friend, “The fault, dear Brutus, is not in our stars, but in ourselves…”
Humans have a tendency to adapt to circumstances with incredible aptitude. Furthermore, we’re psychologically triggered by the presence of certain items or mental models like mere association (e.g., go to the movies, you probably want a Coke and some popcorn). Certain behavioral modification methods such as those employed by Overeaters Anonymous – “Out of sight, out of mind.” – take advantage of this basic fact. You tend not to miss what you don’t see so the solution for some people is to remove temptation entirely rather than learning to overcome it.
What Might the Pay Yourself First Method of Saving Money Look Like in the Real World?
One example of the pay yourself first method is signing up for a dividend reinvestment plan, or DRIP, and having money withdrawn from your checking or savings account automatically each month to buy more shares of your favorite blue chip stock, while also having the cash dividends reinvested automatically without you ever seeing them.
These plans cost little to nothing depending upon the plan specific and amounts involved, and can sometimes be opened with only a tiny amount of money (to learn more read How to Invest With $100 or Less).
Readers of my personal blog know that my family used this method to teach one of my younger siblings about the power of saving, investing, and compounding. By having $50 per month automatically withdrawn to buy her shares of Coca-Cola stock, she was handed almost $13,000 in common equity on her 21st birthday when her UTMA expired. That money was never missed. Nobody ever thought about it because it was never seen. Coke’s program administer, Computershare, came in toward the beginning of the month and extracted it from a checking account as if it were an auto-pay bill. Once she was old enough, even though we had bought the stock without a broker, it was transferred into her personal brokerage account outside of Computershare and now sits in her portfolio, one of several holdings she owns.
Another example of using the pay yourself first strategy would be using the bill pay feature at your bank to automatically pay a “bill” to your Roth IRA as if you were paying the water bill or your mortgage. A check would be automatically drafted on a specific day of the month and sent out by the bank only, instead of going toward an expense, you’d have the payment sent to your brokerage firm. Once the broker received the check, you’d see it show up in your account. Many brokerage firms offer some sort of electronic linking feature, as well, so you can have it pull from your checking or savings account instead of using the bank’s bill pay feature but the net consequences end up being the same for most people and at most institutions.
In fact, the success of the 401(k) plan is due to the pay yourself first method. One of the most fascinating and famous case studies from behavioral economics had to do with different rates of net worth accumulation among various racial groups; a problem for wealth inequality later in life that was so substantial it caused some to wonder if structural racism was at play. Researchers noted that first-generation black employees were not accumulating assets the same way white employees were even when their education backgrounds, salary levels, and other benefits were all but identical. After digging into the data and seeking an answer, they found it: a force called intergenerational transmission. White workers had disproportionately grown up in middle class families with college educated parents. As a result, one of the first things they did when they got a job was run down to the HR department at the urging of their family and sign up for the 401(k), opting to have a certain percentage of their paycheck withheld to invest in equity funds. They never saw this money. As a result, they weren’t tempted to spend it. The first-generation black workers, on the other hand, had no one telling them this and so they not only missed out on the tax benefits and contribution matching, but took more of their paycheck in the form of spendable cash which, once in their checking account, became another source of readily available funds. (The solution ended up being brilliant. Knowing that another area of behavioral economics had uncovered people were far less likely to opt out of a program than they were to opt into it due to inertia bias, 401(k) plans were changed so that all new employees who were eligible began to be automatically enrolled. In short order, the racial disparities between similarly situated white and black workers as it pertained to 401(k) assets began to collapse. Those of you who are passionate about understanding system-wide financial structures should look into it as it’s a powerful illustration of how tiny changes can result in fairer, better, and more equal outcomes for all due to leveling the knowledge playing field.)
The Pay Yourself First Method of Saving Money Is Particularly Effective When You Receive a Promotion or Pay Raise
There is a powerful force known as decimal creep, or lifestyle inflation, that causes otherwise smart people to behave irresponsibly when it comes to money. It happens because beyond a certain point, most men and women measure expenditures in relative terms, not absolute terms; performing a complex, yet almost instantaneous internal calculation about their personal utility and opportunity cost. If you make $40,000 a year and are staying at a nice hotel, you may not be so eager to pay $28 for scrambled eggs and toast from room service. It seems like a complete waste. If you make $500,000 a year, you’re more likely to not worry about it. Whether we realize it or not, most of us value money based on 1.) how long it takes us to earn it, and 2.) how hard it is to earn.
Lifestyle inflation takes hold slowly yet surely. The trick is, the moment your cash flow and income increases, devote all of the additional capital to the pay yourself first method. That is, if your paycheck was $4,000 and you get a raise so it’s going to be $4,600, have that $600 taken out to fund your savings or investments before you ever see it, leaving you the same $4,000 on which to live. By creating artificial scarcity, you’re building wealth and accumulating capital that can be productive purposes; money that can someday shower you with dividends, interest, and rents. You now have an extra $7,200 going to work for you each year. Before long, the power of compounding can work its magic.
In other words, paying yourself first is really the process of buying financial independence. With each check you write, each automatic deduction you have taken out of your account, assuming you’ve invested in prudently, you’re one step closer to being able to enjoy your life, living when, where, and how you want.