Pay yourself first- what does it mean?
Almost every personal finance/entrepreneurship book says “pay yourself first”. It took me a while, but I finally got what it means. In simple terms, it means putting aside money for your future self before you start spending it.
In our July 2021 results, I shared with you a new conclusion I reached. I noticed that even if we spend everything that we (net) earn, we’ll still hit a 40% savings rate. How crazy is that? We can spend EVERYTHING in our current account every month and still hit a 40% savings rate! We can do this because we pay ourselves first AND we automated the process, which is my idea of a lazy utopia.
“How is that possible? if you spend all you earn, you should have a 0% savings rate”
Let me explain.
How to pay yourself first
By the time our salaries show up in our bank account, a huge chunk of it has already been directed to our pensions (which is savings). This means that we paid our (future) selves before our present selves even have a chance to spend that money. This is the first advantage of this approach.
The second advantage is the huge tax savings we make by contributing to our pensions. This is especially true as we have a child. I went into more detail about this in my post about How to increase your child benefit with pension contributions.
However, nothing is perfect except for our daughter. This means there is also a disadvantage to paying a lot into your pension.
The disadvantage, of course, is that money directed to a pension is extremely hard (almost impossible) to get out before retirement age so is very illiquid.
Our mortgage payments are made of (roughly) 20% interest and 80% principal. This means that out of every mortgage payment, 80% of that payment goes towards reducing our debt. Reminder: Your net value is the sum of your assets minus your liabilities. As our mortgage is a liability, decreasing it will increase our net value. This means that 80% of our mortgage payment is, in my eyes, savings.
I went into a bit more detail about this in my post about how to calculate your savings rate.
I like mortgage payments because although they feel like an expense, they are (at least in our case) mostly savings.
What if you don’t have a mortgage and don’t want to contribute to your pension more than the employer match?
Another way to pay yourself first is setting up a standing order to transfer a certain amount from your current account to a savings account, or even better- to your stocks and shares ISA! If you set up that standing order close to your payday, you will be very close to where we are. You will (almost) never see the money in your current account because you pay yourself first. You can’t spend what you don’t have (or can’t see), right?
Actually- wrong, but I will save you from reading a rant about credit cards and loans.
Focus on the big wins
If you pay yourself first and automate your savings in the big amounts, you can (potentially) let loose a bit in your smaller amounts. For example, which would make a bigger difference in your lifestyle? reducing your rent from £1,000 to £900 or doubling your going-out budget from £100 to £200? I’m sure most of you would pick the latter. The difference between a £1000 house/flat/room to a £900 is not a significant one. However, going out twice as much can really make a difference in your life, happiness and your ability to keep on track towards FI.
No, I’m not giving you a green light to get takeaway coffees and eat out every day. I’m just saying that before focusing on pennies, tackle the big amounts first.
For us, that means that after paying our pensions and our mortgage (which are automated of course), we can spend ALL of the money that’s left and still reach a 40% savings rate. Will we spend all the rest? probably not as we want to reach FI as quickly as possible (while having fun along the way of course).
Let’s, for a moment, imagine that we spent all of the money that’s left after pensions and our mortgage.
If we had no savings or investments today and we also started saving 40% today, we would reach FI in 22 years (table below). This number is based on the legendary (yes, I mean that word) article by Mr. Money Mustache titled “The Shockingly Simple Math Behind Early Retirement”. For me, that means retiring at 55, still more than 10 years earlier than most people. Luckily, we already have some investments. We also plan to do better than 40%. That’s why we’re looking at around 10 years.
Why savings rate matters
I want to make an important clarification to the table above. It is accurate regardless of how much you earn. A person with £20k annual income that saves £6k a year will reach FI just as fast as someone earning £100k and saving £30k a year. Yes, they will have different lifestyles once they reach FI but that doesn’t matter. What matters is that they both save 30% of their income and will both be able to reach FI in 28 years.
The pennies count
In the table above, you can see why pennies count. Moving from a 15% savings rate to a 20% savings rate, for example, brings you 6 years (!) closer to FI. I think most people can find a way to increase their savings rate by 5% of their income. 5% can be “won” by optimising your small expenses, it can be giving up cable TV, one takeout a week etc.
I do believe that you need to optimise your expenses, whether it’s a small expense or a big one. However, if you’re just starting and want to automate your savings and pay yourself first- start with the big amounts. It doesn’t have to be the same way we did it. As I said, pensions are highly illiquid and once you contributed- you can’t change your mind. What you could do, instead, is focus on big amounts like rent. Maybe share a flat with a friend or get a slightly smaller flat.
Another big expense for a lot of people is a car. If you could buy a slightly older car, you could use that money towards something that may provide you with a lot more fun. Or, god forbid, live without a car, we’ve been doing this since we arrived in London. I actually never owned a car. However, if your car provides you joy every day and you’re happy with your savings rate- enjoy it! It’s called “personal” finance for a reason, it’s personal.
Do you have other ways of paying yourself first? Let me know in the comments section.