You often hear the term “pay yourself first” when listening to financial advisors. They aren’t always clear on this tem and what it means. Any commission-based advisor will tell you that it means to invest for your future before everything else. But it can mean much more than that!
Get the Best Returns for Your Dollar
Naturally you’re going to want to get the best return on your dollar when you are budgeting for investments and savings. But you also have to look at the debts side of your budget, too. If, for example, you want to invest in a mutual fund or stock that you believe will yield you 8% per annum, but you have a credit card debt that you are carrying, you have to look at the costs of that in comparison. If the credit card has an interest rate of 8% as well, then it seems like it doesn’t matter. But then you have to realise that the credit card is compounded daily! This means that the real rate of the credit card is closer to 10%. You would then be losing 2% by investing over the same period. In this case it is better to pay yourself by paying off the credit card. In doing so, plan for the long term. Once the card balance is gone, then you should take what you were using to pay off the card and turn it into an investment. This is the best way to “pay yourself”. Always go for the higher gains.
What About Paying Off Your Home?
Lately we’ve seen some real ups and downs in real estate and the tanking of the residential market. Some people say that paying yourself first can include paying down your house or investing in a rental property. Of course this can be true, depending on the situation. This is a complex question.
Have a look at your mortgage interest and what you are paying as a percentage there. It’s probably pretty low. Now look at what you can get by investing the money elsewhere. If you have a higher return than what you are paying for interest on your mortgage, then you are making money. What’s even better is if you can pay off your house all at one. If you can do that and then borrow against the house and use the proceeds of that loan to invest, then you make even more in returns! How? The interest on the loan then becomes tax deductible as it is considered a loan for investment purposes, not to buy a personal home. You can do this with a second mortgage on the home, too. Be careful, of course, as you don’t want to stretch yourself, and you certainly don’t want to be paying too much in monthly instalments to your loan.
One way that some investment advisors will suggest you structure this is to get an interest only loan, and use that buy your investments. This way the full value of your payment is tax deductible, and you can then keep claiming that until you decide to cash in the investment and pay off the loan. Such loans, however, tend to have higher interest rates than those that include a portion of the principal in the payment. Of course, a secured loan is also going to have a lower interest rate. Always lower the interest you pay, as much as you can. That is part of the “Pay yourself first” principal – to keep your expenses as low as possible. That way you can use your money to build money for you, instead of paying other people.
What is Good Debt, Then?
This means that you have debt that makes you money. Sounds funny, doesn’t it? The debt that is outlined earlier, where you get both a tax deduction for the interest and have the proceeds making you money that is higher than the interest payment, is a good debt. Bad debt is anything that doesn’t pay you. This is consumer debt, such as credit cards, car loans, and even your house. Sure, we all need a house to live in, but the house isn’t making you any money, that’s why it’s considered bad debt.
Paying yourself first means to put money into things that are going to give you net return. It means that you don’t always have to pay off your debts right away, as long as the money gives you a better return elsewhere. Some advisors insist that you put money away and make it a habit. This is really for those who do not have the discipline to take those bad debt payments and turn them into investment payments once the debt is gone. So, in a sense they are right, because this yields the return of having something later, even when you keep building bad debt for yourself.
Just remember, to pay yourself first, you have to get the best return on your dollar, and that will always steer you in the right direction!
Johanus Haidner - Johanus Haidner (BA, BEd, MBA) is a martial artist, writer, craftsman, artist and life coach in Edmonton, Alberta.
