Last week, I described personal finance as a system of interrelated parts. This may not be a novel way of visualizing personal finance, but it has the potential of being very powerful in helping people to understand not only the parts, but the way that the relationship between the parts affects the outcomes. I have created an image to show what I mean.
Earned Income. Increasing the input of “earned income” will increase the flow through the entire system. It will allow more spending or more saving or more debt repayment (or some combination). Reducing or stopping earned income will reduce or stop the flow through the system.
Saving, Spending and Debt Service. These three “pipes” are related. Together, they receive flow from “earned income”, so that they always add up to 100%. The connector in between them is like a budget. Any combination is possible, as long as the total adds up to 100%. In my case, I saved about 30% of my income, repaid my debt as quickly as possible to minimize interest leakage and spent the rest on my quality of life. I purposely kept my quality of life fairly constant while my earnings increased, in order to commit more money to debt service and savings. Currently, I have accepted some interest leakage by taking on investment debt in order to take advantage of investment opportunities and increase investment income.
Investment. This is a gear to show that money that is invested can produce more money. This becomes an input to the system, although it generally remains in savings until it is required.
Investment Income. Investment income can be produced from interest, dividends or capital gains (selling shares). It can be used to replace earned income either during a period of reduced or stopped income or in retirement. When investment income is equal to (net) earned income is when the system becomes self-sustaining without requiring additional earnings.
Retirement. In retirement, the “savings” pipe will become very small or close altogether. Since the investments are already producing adequate income, additional savings are not required. An emergency fund, however, may need to be replenished with savings. The “debt service” pipe should also be closed, which makes the entire system more stable. At that point, the system becomes very simple, with investment income funding current quality of life.
Any choices that a person makes about allocating their financial resources affects the outputs of the system. The efficiency is affected by the interest cost leakage caused by debt service. The time until it can become self-sustaining depends on the rate of savings and the effectiveness of investment. The current quality of life can be increased either by saving less (longer to retirement) or earning more. Conversely, spending more will have a double impact on retirement by reducing savings and requiring more investment income to fund the chosen lifestyle.