How can the “Pay Yourself First” budgeting method help you achieve your financial goals?
Are you broke at the end of the month?
Many people spend their income thinking that whatever is left at the end of the month can be deployed towards savings and investments. However, in most cases, nothing is left at the end of the month for savings and investments, and financial goals go for a toss. Does the above scenario resonate with you? Don't worry. Budgeting can help you overcome this challenge.
What is budgeting? And why should budgeting be the first step of financial planning?
Are you one of those who don't have money at the month end for savings and investments? Are you left scratching your head wondering where you spent all the money? If yes, then you need to start budgeting immediately. A budget helps you allocate money towards expenses, savings, and investments and track whether the money is used for the intended purpose.
Budgeting lets you control your money by stopping you from overspending or spending money on unwanted expenses. In fact, budgeting helps you direct your money towards productive purposes for fulfilling your financial goals. A budget is a statement of how you distribute your income towards your expenses, savings and investments. Hence, budgeting should be the first step of financial planning.
What is the Pay Yourself First Budgeting Method?
Most other budgeting methods focus on expense management. After managing expenses, the residual amount is directed towards savings and expenses. However, the Pay Yourself First Budgeting method is exactly the opposite of the other budgeting methods.
The Pay Yourself First budgeting method focuses on allocating money towards savings and investments, and then the residual amount can be used for expenses. As this method flips the other budgeting methods, it is also known as reverse budgeting.
Image: Difference between Pay Yourself First Budgeting method and other budgeting methods
The Pay Yourself First budgeting method focuses on setting aside money for savings and investments. You can then channel the money towards various financial goals such as:
- Building and managing an emergency fund
- Paying premium towards term life insurance for family bread earners, health insurance for the entire family, general insurance for assets such as home, vehicle, etc.
- Investing towards various financial goals such as building a fund for a child’s higher education and marriage, building a fund for own retirement. While investing towards these goals, you should ensure the financial products chosen are tax-efficient.
- Building a fund for house purchase down payment, annual family vacation, starting your own business venture, etc.
Thus, the Pay Yourself First budgeting method can help you achieve your financial goals. Once the part of the monthly income is allocated towards savings and investments, you can use the remaining money for regular monthly expenses.
The Pay Yourself First budgeting method can be compared to Warren Buffet’s famous quote: “Do not save what is left after spending, but spend what is left after saving”.
How does the Pay Yourself First budgeting method work?
You may take the following steps to implement Pay Yourself First budgeting:
Make a comprehensive financial plan and a monthly budget
- When you make a comprehensive financial plan, you will have clarity on all the financial goals and the amount you need to invest towards achieving them. When you make a monthly budget, you will have clarity on the total income and expenses and the amount available for savings and investments.
Implement the Pay Yourself First budgeting plan
- As a next step, match the amount you need for your financial goals with the amount available for savings and investments from the budget. If the amount available for investments matches or is higher than the amount you need for your financial goals, you can easily implement the Pay Yourself First budget.
- However, in the case of most people, the amount available for investments will be lower than the amount needed for investments towards financial goals. In such cases, you may consider the following three options:
- Additional income: Increasing income is not in the control of most people. However, you may look for some side projects to earn some extra income, which may be used for investments towards financial goals.
- Reduce expenses: You may reduce some of your discretionary expenses and redirect that money toward investing in your financial goals.
Prioritise your financial goals: Reducing the amount of expenses to the extent of matching the amount required for investments may not be possible for everyone.
- In that case, you may reduce the expenses to whatever extent possible. You may allocate a fixed portion of your income, say 20%, towards financial goals, and use the remaining 80% of income towards expenses. Since the amount available for investments is lower than the actual required amount, you may prioritise your financial goals. You may classify your financial goals as short, medium, and long-term financial goals and accordingly invest towards them.
- With time, your income will increase. You may use the additional income for investing towards your financial goals till you are able to implement the Pay Yourself First budgeting method fully. Later, you can use the additional income to redirect it towards discretionary expenses. In this manner, the Pay Yourself First budgeting method can help you easily achieve your financial goals.
Review the budget every month
- Once you get started with the Pay Yourself First budgeting method, it will take you a couple of months to be comfortable with it. If the actual amount available for investment towards financial goals is lower than the amount required, you should constantly review and reduce your discretionary expenses. Wherever possible, you should cut unwanted expenses and free up resources for deployment towards financial goals. You should keep reviewing the budget every month till you have enough financial resources to invest towards all your financial goals.
Advantages and disadvantages of Pay Yourself First Budgeting
The biggest and foremost advantage of Pay Yourself First Budgeting is that it focuses on achieving financial goals. After allocating money toward financial goals, it uses the remaining resources for expenses. It is unlike other budgeting methods that focus on expenses first, and allocate the remaining money, if there is any left, towards investments. The probability of achieving financial goals with the Pay Yourself First budgeting method is very high.
- May pressurise people to live a frugal life: The disadvantage of this budgeting method is that it may pressurise people to live a frugal life by compromising on discretionary expenses. This will happen when the financial resources available for investment are lower than required.
- Focuses on investments rather than repaying high-cost debt: If an individual has high-cost debt, they should focus on repaying it rather than investing towards financial goals. For example, an individual may be carrying forward credit card debt at an annual interest rate of 36 – 45%. In such a situation, an individual should focus on debt repayment. Once the loan is cleared, they may focus on investments.
Which budgeting method should you start with?
Many people live in a paycheck-to-paycheck situation. They may not be able to start budgeting directly with the Pay Yourself First method. Such people can start with the envelope system of budgeting. Under this method, an individual can take envelopes and title each with an expense category such as grocery, utility bills, travel, etc. You may allocate money towards each expense category and put the money in the envelope with that category title.
You may review your expenses every month and evaluate where you can reduce discretionary expenses. Once you start saving some money every month, you may progress to the 50:30:20 budgeting method. In this method, 50% of income is allocated towards needs, 30% towards wants, and 20% towards savings and investments.
You may continue reviewing your expenses every month. Once you are able to increase your savings rate from 20% to say 30-40%, you may progress to the Pay Yourself First Budgeting method. So, while you may not be able to start directly with the Pay Yourself First Budgeting method, you may start with another budgeting method and work your way up.
Investing in mutual funds with the Glide Invest App
In this blog, we have understood how the Pay Yourself First budgeting method can help you achieve your financial goals. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals.
With Glide Invest, you will get guidance for:
- A personalised risk profile assessment
- Identifying your financial goals
- Appropriate asset allocation
- Making a financial plan for each goal
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- Review and analysis of your financial plan
- Hand holding you till your financial goals are achieved