Everything You Need To Know About Pay Yourself First Budgeting

Pay yourself first is a form of reverse budgeting, a financial management strategy recently(ish) gaining popularity. Unlike traditional budgeting, where you allocate a certain amount for each expense category, reverse budgeting starts with your income and encourages you to save a certain percentage while allowing you to spend the remaining amount freely.

How Reverse Budgeting Works

Reverse budgeting is simple to understand. Instead of creating a budget and allocating money to various expenses, you start with your income and determine how much you want to save. The amount you save is typically a percentage of your income, such as 10% or 20%. It can be for a specific goal or a specific amount.

Once you’ve determined how much you want to save, you can spend the rest of your income however you choose. You don’t need to allocate specific amounts of money for different expense categories, as you would with a traditional budget. Starting with your goal in mind dramatically simplifies the budgeting process, making it easier to stick to.

Here are the steps you can follow to start a reverse budget:

1. Set a savings goal: Determine how much you want to save each month or each paycheck. It could be a fixed dollar amount or a percentage of your income. Make the goal tangible, and it will be easier to stick to, such as a vacation, down payment, wedding, etc. Having a “thing” to save for will make you more disciplined. Figure out how much that “thing” will cost, set a time horizon, and start saving.

2. Calculate your income: Add up all sources of income you receive each month, including your salary, wages, side hustle income, investment income, and any other sources of income. All of it. Everything.

3. Deduct your savings goal from your income: Subtract your savings goal from your monthly income. Pretend that the money is gone already. You can’t touch it. Once you have removed your savings goal from your income, you will know what you have left over for expenses.

4. Prioritize essential expenses: Identify the necessary costs for your day-to-day living, such as housing, food, transportation, utilities, and insurance. The remainder of your income will cover your typical day-to-day and month-to-month expenses.

5. Set a limit for discretionary expenses: Determine how much you can spend on discretionary expenses, such as eating out, concerts, hobbies, and travel. Figuring out how much “fun” money you can spend will help keep you disciplined and from dipping into your savings.

6. Monitor your spending: Keep track of your expenses to ensure you stay within your budget. Use a budgeting app or spreadsheet to track your spending and adjust your budget as necessary. I like the Mint App or YNAB (You Need A Budget), but never underestimate the power of a spreadsheet.

7. Review and adjust your budget: Regularly review your pay-yourself-first reverse budget to see if you’re on track to meet your savings goals. If you’re consistently overspending in specific categories, adjust your budget to reduce spending.

8. Automate your savings: Consider setting up automatic transfers from your checking account to a savings account to make saving easier. Automating savings and investing processes has been instrumental in helping me and my clients make significant progress toward their goals. Automation will help you meet your savings goals without thinking about it. 

By following these steps, you can start a pay-yourself-first reverse budget and begin prioritizing your savings to reach your financial goals.

Pros of Reverse Budgeting

1. Flexibility

One of the most significant advantages of reverse budgeting is its flexibility. You don’t need to worry about sticking to strict budget categories, which is a relief for people who find traditional budgeting too restrictive or difficult to track. You can spend your money however you choose as long as you meet your savings goals.

2. Encourages Saving

The pay-yourself-first reverse budget places a strong emphasis on saving. By starting with your income and determining how much you want to keep, you prioritize saving. It is a great way to build an emergency fund or work towards other financial goals.

3. Less Stressful

Traditional budgeting can be stressful, as it requires you to constantly monitor your spending and make adjustments as necessary. It can quickly become overwhelming when you need to track where every dollar goes. By saving first, you eliminate a lot of the complexity of a traditional budget. 

4. It Can Be Easier to Stick to

Some people find traditional budgeting challenging to stick to because it requires a lot of discipline, self-control, and record-keeping. Conversely, reverse budgeting can be easier to stick to because you have more freedom to spend your money as you choose. Once you have your savings accounted for, there is much less effort to track everything else.

Cons of Reverse Budgeting

1. Less Control Over Spending

While reverse budgeting offers more flexibility than traditional budgeting, it also means you have less control over your spending. It is almost too easy to lose track and overspend, meaning you need to dip into your savings. Dipping into your savings completely defeats the purpose of a pay-yourself-first budget. 

2. Harder to Track Spending

Because you’re not allocating specific amounts of money for different expense categories, tracking your spending with reverse budgeting can be harder. The ambiguity can make it challenging to identify areas where you might be overspending. If you don’t set a hard limit on miscellaneous things, it can be challenging to say “no” when needed. 

3. No Clear Limits

Traditional budgeting provides clear limits for each expense category, which can help you avoid overspending. With reverse budgeting, there are no clear limits, which can make it easier to overspend. The simplicity makes it relatively easy to go beyond your intended limits if you’re not careful. 

Psychology Behind Reverse Budgeting

The psychology behind reverse budgeting is rooted in behavioral economics. Behavioral economics is the study of how people make decisions about money and how they behave when faced with financial choices. People don’t always make “rational” choices when dealing with their money. 

One of the more critical financial cognitive biases to be aware of is loss aversion. Loss aversion affects our logical decision-making processes by valuing losses more than an equivalent gain.

For example, losing $100 hurts more than the joy of gaining $100 from investing. Loss aversion can make saving more challenging because it feels like we are “losing” or giving something up. The best way to handle this cognitive hurdle is to become emotionally detached from your money.

Another principle of behavioral economics that reverse budgeting uses is the concept of mental accounting. Mental accounting is the tendency for people to categorize their money into different “buckets” based on where it came from or how it will be spent.

For example, people might consider money from a tax refund to be “extra” money that can be spent freely, while money from a regular paycheck is earmarked for bills and necessities.

Reverse budgeting taps into mental accounting by making saving a separate category distinct from your spending. By separating your income into “savings” and “spending” categories, you’re more likely to view your savings as something separate and distinct from your spending money. This can make saving more accessible, as you’re not mentally lumping your savings in with your spending money.

Give Reverse Budgeting a Try

The benefits of paying yourself first are that it helps you prioritize your financial goals and ensures that you’re consistently saving and investing for the future. It also removes the temptation to spend money you intend to save, as the money is transferred automatically before you even have a chance to spend it.

By paying yourself first, you’re also setting a good habit. Saving regularly becomes a habit, and like all habits, it becomes easier over time. As your savings grow, you may also become more motivated to continue saving and investing.

Paying yourself first is a simple but powerful strategy for building wealth and achieving your financial goals. By prioritizing your savings and investments, you can make a solid financial foundation that will benefit you for years.

Reverse budgeting is a financial management strategy that has both pros and cons. It offers flexibility and can be less stressful than traditional budgeting, but it also requires discipline and makes tracking your spending harder. The psychology behind reverse budgeting is rooted in behavioral economics, and harnessing that psychology will help you achieve your financial goals faster.