Thursday, June 17, 2010

Pay yourself first. Really?

When researching the internet for advice on personal finances, you will find advice from many people to "pay yourself first". This advice aims to support you in the process to accumulate enough capital to invest on assets. When you get paid you are meant to put away a certain percentage of your income, usually around 10%, for investment purposes.

In principal there is nothing wrong with this, nevertheless I believe that you need to evaluate your circumstances and your objectives before putting money away in a savings account.

Consider the following scenario: You have managed to get an extra $2000 when working overtime. Your cash flow is very tight and you sometimes need to either use your credit to cover day to day expenses. This has led to the accumulation of $10,000 in credit card debt over a significant period of time. You can only afford to pay the minimum payment and this situation continuously stresses you.

The question is, should you put the $2000 away in a savings account earning you 4% per annum or should you use the money to reduce your credit card debt?

If you put the money away at 4% per annum, you will get a total interest of $80.

The other option is to reduce your credit card debt. You pay 11% interest on your credit card balance. This means that at the end of the year, the $2000 will cost you $220 in interest. Therefore if you use the money to reduce your debt you will be saving $140 in one year. Therefore it makes more sense for you to pay the credit card debt than to save the money.

The difference may not be much, but in this case the longer you have the debt, the more interest you pay. This is the magic of compounding interest. In our example, the compounding interest in working against you.

You should always evaluate your options to make decisions on savings versus paying off debt or purchasing assets.


  1. I was reading through my blog's comment and saw you posted twice. I appreciate you doing so.

    I think it's very important that we pay ourselves before anyone else. That way, you can have extra money later on just in case the money you will be paying your lenders would come short, lol.

    Seriously, it's important to save while you try to pay off your debts

  2. What savings accounts pay 4% interest these days? My bank's highest interest savings account pays 1.25%.

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  4. @Anonymous

    Thank you for commenting on my blog.

    I am in Australa where the financial situation is a little different tha America and other countries. The interest rate has been going up in the past year, it has even got to the point where some people are struggling to pay their mortgage.

    Anyway, to answer your question, have a look at http://www, and click on savings maximiser. It is currently paying 4.9% per annum.

    Thank you again for posting on my blog.

  5. @Jonha @ Happiness

    Thank you for commenting on my blog. I appreciated it.

    Your comments are absolutely corrent. The decision on paying yourself first or not is entirely dependent on your financial situation. I agree with you, accumulating a bit of savings is important just in case something happens.

    My advice is tailored for people with serious financial difficulties dut to a high level of debt acquired through purchasing depreciating assets or just nice things. There are many people struggling out there.

    I think that individuals with a lot of unsecured debt should have a little savings, as you suggest, but once they are confortable with that they should focus on paying off the debt before it the balance grows to an unmageable situation.

    Again, common sense and applying each advice to your own situation is always a good start.

    Thank you for posting on my blog, I really appreciate each and every comment.