Pay Yourself First – Save Before You Spend !

A farmer sows seeds and nourishes the fields over time to ensure that the seed grows into the desired crop. After harvest he sets aside some of the grains seed purposes, and uses/sells the balance. If he does not retain some grain as seeds, he would have to buy from the market to sow in the next season. This simple example explains the importance of the age-old savings/investment strategy – “Pay Yourself First !!”

What is Paying Yourself First ?

It is a common practice, esp. for the middle-class segment, to pay off all bills due in the month, the moment we get our pay check. We navigate through the month catering for the essential expenses as well as some discretionary ones. On most occasions find that we are almost over with money by the month end. In some cases, we might find some balance in the account more than what we are used to, and it is then that we think of putting it somewhere as a saving or investment.

The Pay Yourself Strategy involves setting aside the portion meant for savings/investments as soon as the pay check is received, and utilizing the balance to cater for the routine expenses. So, essentially rather than saving what is balance after spending, you are saving before you spend. A pre-requisite to be able to do this is that you should have prepared a monthly budget.

What is Budgeting ?

Budgeting is an important control measure in financial management. We often think that it is applicable only to government expenditure, or business management. We generally tend to overlook it in our personal matters. One should realize that it is one of the most essential and fundamental aspect of personal financial management. A lot of it happens automatically, but to be able to optimize the financial plan, one should try to do it in a very deliberate manner.

Budgeting means to decide the quantum, or limits of expenditures for identified purposes over a defined period. In personal  matters, it could be monthly budget for essential expenses, and monthly/quarterly/semi-annual/annual for discretionary expenses. Essential expenses are those which are not avoidable like rent, transportation, bills, food and education. Categorize the expenses which can be undertaken if additional funds are available, but won’t affect much if deferred or cancelled, as discretionary expenses. This would include dining out, vacation, gifts and lifestyle related expenses.

How do You Budget ?

Initially, one can do some back of the envelope calculations to arrive at own monthly budget. However it is advisable to keep a record of all transactions over time and arrive at the actual spending pattern. A meticulous record will help us restructure our spending pattern  to optimize own savings.

The first step is to correctly assess the income in hand after all the basic/mandatory deductions as applicable including tax. The second step is to arrive at the amount required for essential expenses for the month. The third step is to identify the discretionary expenses for the month. The balance left from the income after catering for the essential and discretionary expenses would be what is immediately available for planning the savings/investments.

Following the Pay Yourself First Strategy would involve transferring this identified surplus immediately to its intended avenue, or a separate account. From here it can be deployed in the desired investment in a planned manner. We had discussed the importance of having at least two separate personal accounts in the article “ Are You Organized for Investing” . As a guideline not more than 50% of income should be utilized towards essential expenses, and less than 30% towards discretionary spending.

How Much Should You Save ?

  In order to build a nest corpus for future financial objectives including retirement, it is necessary to save regularly. As a benchmark, at least 20% of the income should go towards savings/investments. This percentage can increase over time with age and increasing income levels. In case one feels that the expenses are not permitting the desired level of savings, then one should ruthlessly cut down on the discretionary spending. One common folly is the inability to differentiate the essential expenses from the discretionary, leading to many holes in the household budget. All Lifestyle related expenses should be categorized as Discretionary Expenses.  

Recommendations

(a) Keep a record of all expenses, and over time assess the required monthly budget. If required use some mobile/desktop money management software like Microsoft Money or free accounting software Gnucash.

(b) Be careful in segregating the essential expenses from the discretionary expenses.

(c) Maintain a separate account for investment purposes, and transfer the amount earmarked for savings/investments immediately on receipt of income.

(d) Ensure that at least 20% of monthly income goes towards savings/investments.

(e) Review your budget regularly to weed out wasteful and redundant expenses. The essential expenses and discretionary expenses should always remain limited to 50% and 30% of the income respectively.