The concept of paying yourself first has been popularized over the last few years, though many still find it difficult to implement into their financial lives.
Simply put, the concept is as suggested, a person ‘pays’ (i.e. saves) themselves from their income source before any bills are paid. Even if it’s a smaller amount, say 5 or 10% of their take home pay, this amount is prioritized over all expenses. In fact, it’s best to think of this as an expense to reinforce its necessity. This way a person knows they have to set this money aside in order to pay the expense (to themselves).
While this sounds great in theory, how should one go about implementing this saving strategy? The short answer: friction.
Most people have the majority of their net worth in a 401k plan. This is because they have automatic contributions set aside and deposited into their 401k. Furthermore, there are severe penalties and tax consequences from withdrawing these funds before retirement, i.e. friction. This allows the balance to go untouched and added to, allowing for compounding over the years and thus a sizable nest egg once a person reaches retirement.
The same friction points do not exist for personal savings, and rightfully so. People should have access to their money when they need it. However, a person can take steps to create this friction for themselves, thus allowing for the balance to go untouched and compounding to take effect.
It is also helpful to have a savings goal in mind, such as for a down payment on a house or an emergency fund. Each savings goal should have its own account to keep restricted funds separate. Furthermore, these accounts should yield market interest rates (currently around 4%) to allow for maximum compounding.
Here are a few simple steps to accomplish this:
Have a separate savings/money market account opened for each savings goal. Ensure you are being paid a fair interest rate on your savings. It’s also best to use a different bank than where your regular checking account is held, this way there’s less chance of transferring your savings out (i.e. friction).
Split your paycheck to have funds sent to these accounts directly. You can do this by logging into your employer’s payroll provider portal or contacting your HR department to change the settings for your direct deposit. In general only 5-10% of your paycheck should go into these savings accounts to ensure you have enough money to pay your other expenses.
Once you have a sizable savings amount, you can deposit them into a Certificate of Deposit (CD) for even higher interest rates. CDs restrict access to your money for 3-24 months, depending on which you choose, and pay you interest at the end. This is a very effective way to set aside money for a specific goal in the future. For example, if you know you’re going to buy a house next year, you can put your down payment savings into a 12 month CD to ensure the funds are there when you need them. The downside to CDs is that you cannot add to them once they are open, so you’ll need to have some savings aside already.
If you’re curious to learn more about savings strategies such as this or would like a free consultation please visit evcmcom.com/contact.
Happy investing!