Saturday, January 10, 2015

Don't "Pay Yourself First". Think Like an Owner and Pay Yourself Last.

Too many financial gurus are expounding on the virtues of "paying yourself first." The idea is that many people find themselves not saving enough (or any) from their paychecks after paying their monthly expenses, and that the solution is to "pay yourself first", by automatically deducting a portion of your paycheck toward your savings before using any of it to pay bills. Is that smart?

Absolutely not.

You must pay your debts first. If you prioritize savings and pay yourself first even at the expense of defaulting on your debts, your debt accounts will go into collection and it will eventually cost you a lot more money, most likely far more than you could earn from your savings. Plus, paying your debts is the honorable thing to do. You promised to pay when you first incurred the debt, and now you must live up to the promise.

Moreover, if you have credit card debt charging 17% interest rate, and you only make 5% on your savings, what good will paying yourself first do? Instead, pay the credit card company, as much as you possibly can in this example, and you will make the equivalent of a risk free 17% on your money.

Your income and expenses are not fixed month to month, but can fluctuate widely. For example, if you budget 50% of your income for fixed expenses and 30% for pleasure spend money, you might autopilot a pay yourself first program by automatically deducting 20% from your monthly paycheck. That in and of itself can serve as a disincentive to save more. After all, you have already saved money that month, and you even paid yourself first! Now what if your actual total expenses in a particular month drop to only 40%? You might decide that since you paid yourself first and then everyone else as well, whatever is left is free to spend away as you wish. That mentality just cost you a whopping 40% of your paycheck that month. On the flip side, unexpected expenses do pop up from time to time. By paying yourself first, you are effectively reducing your flexibility to meet these unexpected expenses, which may even cost you to go into debt and setting you back in your financial journey.

What should you do instead? 

Think like an owner. Take a look at any income statement, such as 3M's for example. Do businesses pay themselves first, by fixing a particular profit from revenue before any expenses are deducted? No honest business would do that. Instead, you see that from the top line, total revenue, the business would then deduct all sorts of expenses to include debt and taxes, before finally arriving at the bottom line, net profit. That's right, real owners pay themselves last. Everything that remains after you pay your creditors belongs to you. Your job is to maximize that bottom line.

Your task is to fix your expenses to as low as possible, so they don't rise with your income, or at least not nearly as much. By paying yourself first, you are essentially treating yourself as just another creditor among many. That mentality leads to enslaving yourself to whatever you end up splurging your residual income on. You owe it to yourself to pay yourself last.

Paying yourself first is forced savings. And by experience we know that no good ever comes by force. You must learn to save willingly. That is how pay yourself last works.

Track every penny you earn and spend each month and record them in a monthly income statement for yourself. Here are mine as an example. Each month, you don't know exactly how much you will end up in your bottom line, your savings. Instead, you try to maximize your top line, gross income, and minimize each line of expense. Each month is a new adventure for you. You compete with yourself each month to see if you can top your savings rate from the prior month. You will see how your savings grow month to month, then year to year, and how they will eventually outpace the growth in your expenses. 

Remember, debt is fixed, and the sky is the limit for equity. If you pay yourself first, you are but a debtor. If you pay yourself last, you are truly an owner.

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