Passive income is the holy grail of financial independence and retiring early (FIRE). By saving and investing over time your money you will gradually accumulate and develop streams of passive income. Eventually, the various passive income streams will provide enough income to meet (or exceed) your living expenses. At such a time you will have ‘FU money’.
Before discussing passive income in further detail, lets outline why FU money is so great. FU money gives you the ability to tell your boss to ‘F$*! Off” and quit or retire. There are unlimited options when someone has FU money. FU money provides the freedom to stop working, work a lower paying job that you are passionate about, travel full-time, stay at home with your kids, or just veg out and watch Netflix (and chill) all day. In a nutshell, FU money provides the flexibility to do what you want when you want. Who would not want that?
Now what is passive income and how does it compare to other types of income? The chart below outlines the 4 traditional ways to earn income; which are being an employee, being self-employed, being a business owner (others working for you), and being an investor.
Being an employee (top left on the chart) is the most common and possibly WORST way to earn an income (but not a PASSIVE income…. hang with me. we will get there soon).
As an employee, you are trading time for money. Essentially, you are a paid servant to your employer and your livelihood DEPENDS on you showing up to work Monday thru Friday from 9-5. You are sacrificing your most valuable resource (time) in exchange for money. Sounds… well… HORRIBLE. Ironically, the worst form of income is also the most common form of income. In the United States, many people never escape this form of income because of the consumer lifestyle and individuals’ tendencies to live paycheck to paycheck.
Being self-employed (bottom left on the chart) is another form of income. However, like being an employee, you are still trading time for money. Self-employment does provide more flexibility and freedom than working for someone else, which is a big plus. However, not everyone can or wants to be an entrepreneur. Some people like the safety net of a salary and working for ‘The Man’ (sounds a little crazy). Other people thrive working for themselves and being able to make as much or as little as they want. Being self-employed also allows you to set your own hours and own pace.
The third way to make an income is from owning a business (top right on the chart). In this instance you are utilizing leverage of OTHER people’s time to make money. Depending on the nature of the business and how well established the business is, this can provide a (mostly) passive income. While it is nice to profit off of others time and effort, owning a business will require at least some oversight.
Last but certainly not least! Being an investor (bottom right on the chart) provides passive income (WE FINALLY MADE IT!). Now what the heck is passive income?
Passive income is “income that is received on a regular basis with little or no effort required to maintain it”. What does this mean? It means you are getting paid while giving up little or NO TIME (remember, time is the most valuable resource). Sounds too good to be true, right? But its not!!! Passive income is quite common place if you know where to look! [hint: keep reading! I am about to tell you about several types of passive income]
Unfortunately, this concept is foreign to many individuals, especially Americans. According to one survey, a majority of Americans plan to work into their 70s or never retire. Another survey stated, “1 in 3 Americans have saved $0 for retirement.” Clearly, many people do not know about or understand the concept of passive income and what freedoms saving/investing provides (Blame the lack of financial literacy in the education system).
There are several forms of passive income. Two of my favorite sources of passive income are dividends from stocks and rents from real estate (more types later).
Dividend stocks are an amazing thing! Most dividend paying stocks provide shareholders with a predictable income every quarter (3 months) in the form of cold hard cash. However, some companies offer monthly, semi-annual or annual dividends. Many companies increase their dividends every year and the increase often outpaces inflation. This means you are actually making more money over time without even lifting a finger (say wow)! Additionally, dividends have preferential tax treatment and are subject to the capital gains tax and not personal income tax (read: dividends are taxed less than income earned from a job). Sounds pretty good, right?
Real Estate or rental income from properties is another form of (mostly) passive income. Personally, I love real estate and the passive income that it provides. Most months, the only time commitment is collecting the rent checks. Over time, like stocks, rents generally increase with or outpace inflation. This equates to greater earnings over time. Additionally, tenants are paying down your mortgage and there are tax benefits to owning the real estate.
Owning rental properties does come with occasional expenses such as repairs and maintenance. Tenants may cause the occasional headache as well. Thankfully, I have been fairly lucky with screening my tenants; most of them are very pleasant people who I have a great relationship with. Individuals may hire a property manager for a modest fee (typically 8-10% of the gross rent) if they do not wish to deal with tenants or repairs. Utilizing a property manager makes owning real estate 100% passive income. I will write more on my real estate endeavors in future posts.
There are countless other types of passive income. Bonds provide passive income through their regular interest/coupons payments. Peer 2 Peer lending, which has grown tremendously in the past few years, can also provide passive income to investors.
Royalties are another form of passive income. A royalty is a small payment received by a creator every time an item is purchased or a song is played. Individuals can invent a product, write a book or song and receive royalties for the intellectual property they create.
Banks will pay you interest on your deposits held at their firm. Additionally, Banks offer a product known as Certified Deposits or “CDs” for short. Banks also pay interest for money held in a CD. Both of these are examples of passive income since your money just sits there MAKING YOU MORE MONEY. Historically, interest rates for deposits and CDs have rewarded savers/investors. However, given the current low interest rate environment, many individuals would be better served putting their money elsewhere.
In conclusion, there are four traditional ways to earn income. Some methods for earning income are very time intensive while others are very passive. Working for a company or individual provides income in exchange for time. Stocks, bonds and real estate are a few of the many ways to generate passive income. Time is the most finite and valuable resource that we all possess. By saving money earned as an employee, we can invest the savings into assets that will provide passive income. Over time the passive income will grow, provide financial freedom and give you the flexibility to spend your time as you please.
Currently, I find myself positioned in all 4 quadrants on the chart above. Unfortunately, a majority of my income comes from the left side of the chart. I value my time more than anything and am working towards leaving the ranks of an employee. As a result, I am focusing my efforts on growing my passive income through investing in dividend stocks, rental properties and other passive income producing assets. No one has ever laid on their death bed and said, “Gee, I wish I spent more of my life working.” With that said, what quadrant do you want to be in?