Pay Yourself First: Reverse Budgeting Explained

Budgeting, Personal Finance
Pay Yourself First: Reverse Budgeting Explained

If you often have little or no money left over at the end of the month, or you just want to save more, a proactive budgeting approach can help. One effective method is known as reverse budgeting, or the “pay yourself first” budget.

Don’t get too excited: This budget doesn’t advocate treating yourself to a new pair of shoes or an expensive dinner before taking care of expenses. It actually suggests putting your money toward savings before paying your bills.

Could reverse budgeting be a game changer for you? Here’s what you should know before giving it a try.

How to build a reverse budget

With reverse budgeting, you build your spending plan around savings goals, such as retirement, instead of fixed and variable expenses.

Some budgeting rules of thumb still apply, says Rachel Podnos, a certified financial planner in Washington, D.C. For example, you’ll want to save for an emergency fund and retirement before other goals.

Here’s how it works: Let’s say your monthly income is $3,400, and each month you want to save $150 for your emergency fund, $200 for retirement and $100 for a new motorcycle. Set aside that $450 first, then use the remaining $2,950 toward other costs, such as rent, groceries, utility bills and loan payments.

To create your own reverse budget, list your savings goals, be they short term, long term or a combination of both. Retirement and your emergency fund should be your first priorities, but if you have others, contribute a small amount to each or pick a few to focus on first. Then decide how much you need to save to reach those goals and what portion you can afford to sock away each month.

How much should you pay yourself?

Pinpoint a realistic amount using the 50/30/20 approach. This method allocates 20% of your monthly income to savings and debt repayment, 50% to necessities and 30% to wants. With a $3,400 monthly income, you’d reserve no more than $680 for savings and debt repayment, $1,700 for needs and $1,020 for wants.

Note that the savings and debt repayment category refers mainly to savings for an emergency fund and retirement. Deduct savings for expenses such as travel, a wedding or a new home from the needs and wants categories.

If you find yourself coming up short in all the categories, try supplementing your income with side gigs. Just figure out how to make money in a way that fits your situation.

» MORE: What is my take-home income?

The upsides

The reverse budgeting method is low maintenance compared with others, such as zero-based budgeting. It doesn’t require you to categorize every expense or keep a detailed record of your spending.

“Instead of figuring out ‘Where do I cut back and therefore how much can I save?’, just make a decision about how much you’re going to save. The ‘where to cut back’ takes care of itself,” says Ken Robinson, a certified financial planner in Cleveland, Ohio. “That’s the real virtue of paying yourself first.”

Automation is a simple way to pay yourself first. Set up contributions from your pre-tax salary to your 401(k), if you have one. And use an app or log onto your bank’s website to arrange automatic transfers from your checking account to your savings account or IRA.

The reverse budget can help you focus on the big picture and reduce impulsive purchases. When people save first, they have less money to spend, and tend to use the remainder on things they need or value, Robinson says.

» MORE: How much can I spend each month?

The downsides

It is possible to save too much. If your goals are overly ambitious, you risk not having enough to cover your expenses, such as housing and groceries.

To make this budget successful, you’ll have to prepare. Podnos recommends reviewing your typical spending by pulling up your bank and credit card statements.

“Do the math and start conservative,” Podnos says. “You can always increase [your savings contributions] later. You don’t want to risk an overdraft or bounced check or something like that.”

Prioritizing savings over other goals might not always be in your best financial interest, either. For example, if you have toxic debt — such as a high-interest credit card balance — we recommend tackling that before saving up for a vacation or a new car. Podnos suggests classifying your debt payments as savings to help resolve that issue.

» MORE: Budget worksheet

Ready, set, save

Paying yourself first is a great option if you prefer a hands-off budgeting system or don’t want to feel as though you’re budgeting at all. Remember to automate your savings for an easier experience.

If you need more structure, consider a more involved budgeting method such as the envelope system, which portions out your entire income toward all of your expenses at once.

Lauren Schwahn is a staff writer at NerdWallet, a personal finance website. Email: lschwahn@nerdwallet.com. Twitter: @lauren_schwahn.