How Does “Pay Yourself First” or “Bank on Yourself” Really Work?

Written by Trent Hamm, The Simple Dollar is a popular personal finance blog that chronicles one man's road back from overwhelming debt to financial security. Hamm declared the contents of the blog to be in the Public Domain in 2008 and available for sharing when attributed properly. We will share a couple of posts a week.

 

 

 

How Does “Pay Yourself First” or “Bank on Yourself” Really Work?

 

 

 

I often see and hear ads for programs that involve the ideas of “banking on yourself” or “paying yourself first.” They’re pretty prevalent on talk radio and you’ll sometimes see ads for programs like these in the newspaper or in the back of financial magazines.

 

The claims made in the ads seem extraordinary. Many of them claim to allow you to eventually borrow money from yourself rather than borrowing money from a bank when you need to make a major purchase (like buying a home). Many also claim to provide a road straight to financial independence.

 

It should be noted that I’m grouping several different systems together into one post. There are a lot of variations on what I’m about to describe. The information below doesn’t describe any one system exactly, but many of these programs follow the same general framework.

 

Here’s how the system works in general.

First of all, you have to establish a “master account” of some kind. This can be something as simple as a savings account at a bank or it can be an investment account where you introduce some risk to your “master account.” I’ll talk about the different options in a bit.

 

This “master account” is where you deposit all of your income. Every single dime you earn gets directly deposited into your “master account.”

 

Then, once a month (or once a week or however you choose to do it), an automatic transfer pulls a smaller amount of money out of that “master account” into your normal checking account. That is the money that you live on – you use it to pay all of your bills.

 

Let’s say, for example, that our friend Donald brings in $1,000 a week. He figures out that he can live on $2,800 a month – this will cover his rent, his food, and his other bills while leaving some money for personal enjoyment.

 

So, he sets up his paycheck to be automatically deposited into his “master account” at the start of a month. At the end of that month, he has $2,800 withdrawn from that account straight into his checking account. He then lives off that $2,800 for the next month.

 

Remember, of course, that he’s actually bringing home $1,000 a week. At the end of the month, he’ll have a $4,000 balance in that account (maybe $5,000 depending on how the weeks break, but we’ll stick with $4,000 for the example). So, after the monthly withdrawal happens, he’ll still have $1,200 in that account.

 

This repeats over and over again. Over the course of a year, he’ll wind up leaving behind $18,400 in that account. That money is going to earn interest and may be earning more than that if it’s invested in other things.

 

Using the master account as a “bank” is simple. Eventually, the “master account” will build up enough balance that it can serve as a personal “bank.” Rather than borrowing money from a bank for a mortgage or a car loan, you’d “borrow” money from the master account for those expenses, but you’d enter into a “repayment plan” for that money you “borrowed.”

 

Let’s say that after the second year, Donald has $38,000 in the account. He decides to buy a car, but he needs $10,000 to pay for it. He withdraws $10,000 from his master account instead of borrowing that money from a bank. However, he agrees to a repayment plan where he’ll pay that money back – with interest – over the next 5 years. He decides that he’ll end up repaying back $12,000, which would mirror the interest he’d pay on a normal car loan, and if he divides that by 60 – the number of months in five years – he ends up with a $200 a month payment.

 

So, he just changes his monthly withdrawal from the account down to $2,600 a month and remembers that he can bump it up by $200 a month in five years. It’s the same as automatically making a $200 a month car payment, except that he’s repaying himself.

 

So, should you use an investment account as your “master account”? Since this is theoretically a very long-term solution, meaning that you’re not going to tap significant portions of the balance for many years, it can make sense to invest the money in your “master account.” However, you put yourself in a bit of a precarious position right at first because your balance is so small – if the investment you choose hits a snag and the balance drops, you might run into trouble with your first few months of “income” to your checking account.

 

So, my suggestion is to put it in an investment account, but start off in a money market fund until the balance is solid. The money market fund will have a low return, but it won’t drop and you’ll be able to make safe withdrawals. Once the balance of your “master account” is equal to several months of your pay, then you can move it to higher risk investments with higher return potential.

 

This system does not mean you don’t need an emergency fund. You should treat your “master account” as essentially nonexistent in terms of day-to-day financial life. It only exists as a potential lender when you’re making a major purchase and perhaps eventually as your retirement plan. You should still have an emergency fund as normal, except you need to build it out of your monthly “income.”

 

Would I adopt this system? I think it does a great job of enforcing financial stability onto a person that’s currently enjoying a state of spending significantly less than they earn but still have some financial hurdles in the future. It would work best, I think, for someone who recently received a large bump in income, such as a college graduate entering into their first professional job or someone who just took a major leap in their career.

 

If you already find it natural to spend significantly less than you earn and you save up for your big goals, this system wouldn’t really change anything for you. That’s the situation we’re in. We essentially intend to pay cash for every major purchase for the rest of our lives and we have a significant portion of our net worth invested already, so this system doesn’t gain much for us.

 

I wish I had adopted this system on my first day at my professional job in 2002 as it would have made my financial life much easier. I was already accustomed to living on a college student’s income, so it wouldn’t have hurt to have a small “income” coming in using a “bank on yourself” system.

 

Will it work for you? Like I said, I think this system works best when it’s not enforcing a financial shock to your day-to-day life, so it would really work best to initiate it after either receiving a big raise or paying off a significant debt. If that’s your situation and you want to make the most of that change, this is a system well worth considering.

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