One of the most fundamental ways in which the wealthy think differently about money is that they don’t go out and work for their money. Their money works for them.
While they’re playing with their kids, teeing off, or hiking in South America, they’re earning money. Therein lies the beauty of passive income: It streams in without you having to lift a finger.
Investing for passive income doesn’t just serve your long-term financial goals. Your investments can earn you income right now.
Why Invest for Passive Income
People invest in income-producing assets for many reasons. Who wouldn’t want to earn more money without having to go out and sweat for every cent?
A few of the more common reasons why investors pursue passive income include:
- To Enjoy an Early Retirement. No one says you have to wait until 65 to retire. With enough passive income, you can cover your living expenses so working becomes optional. That simple concept serves as the foundation for the financial independence, retire early (FIRE) movement: You can retire young if you pump enough savings into income-producing investments. I’ve known teachers who have retired at 30 because they built enough passive income from rental properties (more on that shortly).
- To Enjoy a More Comfortable Retirement. Yes, you’ll probably collect a (small) check for Social Security benefits each month after you retire, but that doesn’t mean you’ll be living large. The more passive income you earn from your investment portfolio, the better quality of life you can lead in your later years.
- To Reduce Dependence on Their Job. Being fired ranks among the worst experiences most of us face. It leaves you feeling not only rejected and broke, but it also lays bare your dependence on others for your livelihood. Losing your only source of income makes you feel utterly helpless. When you have other sources of income, however, you don’t feel nearly the same helplessness or desperation to find a replacement job immediately. You can take your time and find the right job at your own speed.
- To Ditch Their High-Octane Job for Something They Love. High-stress, high-income jobs tend to lock us with golden handcuffs. We succumb to lifestyle inflation, then find that we can no longer afford to leave that high-stress job even when we grow to hate it. With passive income, however, you can walk out the door and pursue your passion, even if it doesn’t pay as well. You may even take a job that lets you work remotely so you can drop the commute, work from home, or move wherever in the world you want to live.
- To Live Anywhere. With enough passive income, you sever your tether of your job, and thus the need to live near it. There are plenty of countries where $2,000 a month buys a comfortable lifestyle — in some cases, even a luxurious one. Build $2,000 in monthly passive income, and you can live out your dream adventures wherever you like.
- To Build Wealth Quickly. Wealth begets more wealth, and nowhere is that clearer than with passive income. Imagine someone handed you a rental property earning $1,000 per month in passive income, and you set aside your newfound extra income and invested it as a down payment for another property. Now, you have two properties generating income, so you can save up the next down payment even faster — and the next, and the next, in a self-perpetuating cycle of higher income and wealth.
Sources of Passive Income
Passive income sounds great, but where does it come from?
You can earn passive income from many sources, but they all share one thing in common: They require money, work, or both to create. You invest these upfront, and then you get to reap the benefits. This is precisely why so few people earn passive income. They lose interest when they realize how much upfront investment it requires of them.
If you’re not afraid of a little investment of time or money, read on, and pick and choose a combination of the following passive income sources to fuel your adventures for the rest of your life.
1. Dividend-Paying Stocks & Funds
One of the simplest and most common forms of passive income is dividends from stocks, mutual funds, or exchange-traded funds (ETFs). You buy a share, and that share pays you a dividend each quarter indefinitely.
Some stocks pay higher dividend yields than others, of course. One stock may pay an annual yield of 1% of its share price, while another pays a yield of 5%. To reduce the risk in your stock portfolio, consider buying ETFs that own a wide range of dividend-paying stocks, so you don’t over-invest in any one company. There are hundreds of ETFs that specialize in dividend-paying stocks. Three good examples are SPDR S&P Dividend ETF (ticker: SDY), SPDR S&P Global Dividend ETF (ticker: WDIV), and ProShares S&P 500 Dividend Aristocrats ETF (ticker: NOBL).
With their high liquidity, easy diversification, strong historic growth, and low initial cash requirement, stocks remain an easy starting point for passive income investing. Open a brokerage account if you don’t have one already. It takes all of five minutes. I use Charles Schwab because they charge no commissions and offer an excellent free robo-advisor service. There are also several other brokerage accounts that offer a cash bonus for opening a new account.
The other classic “paper asset,” bonds typically pay out interest payments until they mature and you get your initial money back. If you’re new to the concept of bonds, they’re basically a loan from you to a borrower, which you can sell on the secondary market to another investor at any time.
Bonds come in two fundamental forms: government bonds and corporate bonds. Some government bonds, including many local municipal bonds, come with tax benefits for investors.
In recent years, bonds haven’t paid out the same high returns that they did in the 20th century. In an environment of perpetually low interest rates, many investors have a hard time getting excited about bonds.
Still, bonds have historically played an important role in reducing sequence of returns risk for retirees. Because bonds tend to be lower-risk, lower-return investments, many investors gradually buy more bonds as they approach retirement as a strategy to reduce risk through their asset allocation.
Pro tip: If you’re interested in support small businesses you can purchase bonds through Worthy. You’ll earn a 5% return and you’ll be helping a small business grow.
3. Rental Properties
Rental properties are a great source of passive income. They generate ongoing income without you having to kill the golden goose and sell off any assets. That means you don’t have to worry about safe withdrawal rates or sequence of returns risk as you approach retirement — at least not for your rental portfolio. In fact, real estate assets drive your net worth higher over time, as the properties (hopefully) appreciate in value and your tenants’ rent payments pay down your mortgages.
Rents also adjust for inflation, so you don’t have to worry about inflation diminishing your returns. The returns are predictable because you know the purchase price of the property and the market rate for rent, and you can accurately forecast the long-term averages of all expenses.
Landlords can mitigate the main risks of rental properties through aggressive tenant screening and rent default insurance and through property management best practices, including semiannual inspections. And as a cherry on top, real estate comes with outstanding tax benefits.
That said, rental properties aren’t a good fit for everybody. They require skill and knowledge to invest in profitably, which is precisely why so many new rental investors end up losing money. Rental properties also require many thousands of dollars of cash upfront in the form of a down payment and closing costs, which makes diversification a challenge at first.
Real estate is also notoriously illiquid. It costs a great deal of money and time to cash out your equity by selling.
Only invest in rental properties if you’re genuinely interested in learning the ropes and making a hobby or business out of it. If you’re only interested in diversifying your assets, you have plenty of easier options for gaining exposure to real estate, including real estate investment trusts (REITs).
Pro tip: If you’re interested in purchasing a rental property, consider Roofstock. They have hundreds of turnkey properties available and they even guarantee you’ll have a tenant within 45 days or they’ll cover the rent for up to 12 months.
4. Public REITs
Through your brokerage account, you can buy publicly traded REITs just like stocks or ETFs. That makes them the most liquid option for investing in real estate. Unfortunately, it also makes them the most volatile.
The SEC requires publicly traded REITs to pay out 90% of their profits in the form of dividends. That means REITs tend to pay high yields, but it’s difficult for REIT managers to grow their portfolios, which limits REITs’ growth potential.
If you want a fast and easy way to diversify your portfolio and add real estate, public REITs are a great first step. But because they trade on stock exchanges, they tend to move more in line with stock markets than other real estate investments, limiting their upside as a diversification strategy.
5. Private REITs
Private REITs are another story. These privately owned funds typically invest in commercial real estate — often apartment buildings — and allow individual investors to buy shares in the funds.
Unlike publicly traded REITs, private REITs don’t offer much liquidity. Most funds clearly state that they represent long-term investments, often five years or longer. Some allow investors to sell their shares early, but usually with a penalty.
For investors who don’t mind parking their money and leaving it, private REITs can be a great source of passive income. Streitwise, for example, has paid out a 10% yield consistently for years. Fundrise also offers an income-oriented REIT option, which pays a 4.5% to 4.9% yield in dividends plus annual appreciation in the 4.1% to 4.6% range.
Some private REITs also invest in real estate-secured debt, not just direct property ownership. This helps them pay out more ongoing income in the form of dividends to investors, rather than investors relying solely on rental cash flow from their buildings.
6. Crowdfunded Real Estate Loans
Another indirect way to invest in real estate is investing solely in real estate-secured debt. In the past few years, a wide range of real estate crowdfunding websites have arisen that don’t invest in real estate directly at all. Instead, they serve as hard money lenders, making short-term purchase-rehab loans for house flippers.
These sites lend money for a flipper to buy and renovate a house, then they recoup that money through investors like you. In many cases, they let you pick and choose individual loans to fund, and they pay interest based on the degree of risk in each particular loan.
One example is Groundfloor. First, they allow nonaccredited investors to participate. (Accredited investors must have a net worth above $1 million dollars or income of at least $200,000 for singles or $300,000 for married couples.) Second, they allow you to invest with as little as $10, making it accessible to even novice investors just getting started.
Best of all, the loans are short-term — usually 9 to 12 months — so you don’t need to commit to many years like you do with many other real estate investments. You invest your money and collect it back with interest later in the year. That’s assuming the borrowers pay their loan back, of course, but no investment comes without risk, and Groundfloor has a strong track record of collecting their loans.
7. Private Notes
A private note works similarly to real estate crowdfunding, but without the lender as the middleman. Instead, you directly lend money to another person or company. Ideally, this is someone you know and trust implicitly, because if they don’t pay you back, you don’t have many options at your disposal beyond guilt-tripping them.
I lend money sometimes in private notes to real estate investors I know and trust. For example, I lend money to that teacher who retired at 30 and her husband for their rental investments. They get flexible financing, and I earn a high return without having to mess around with screening tenants or unclogging toilets. They’ve always paid my interest on time.
Be careful with this option if you don’t operate in the real estate investing world yourself. The risk directly correlates with how well you know the borrower and your confidence in their experience.
8. Business Income
I own an online business that I love and plan to continue managing for many years to come.
My partner, however, is nearing 60. She no longer feels the same affinity for the headaches and stresses of running a business, so we’ve started planning her exit.
That doesn’t mean she’ll stop earning money from the business. Although her salary will cease, she’ll still earn distributions as a business owner, even if she never breathes the name of our company again.
Starting a business allows you to leverage other people’s time and money to create your own passive income engine. What starts as a hobby business can evolve into something larger and more complex that takes on a life of its own. And a successful business continues generating money even after you hire someone else to run it for you.
Explore some potential hobbies you could grow into a money-making business, and build your own empire that endures even after you bow out.
9. Literal Income-Generating Machines
Still looking for passive income ideas? Consider actual income-producing machines, such as laundry machines, ATMs, arcade games, bar games, or vending machines.
The hard part of this strategy is finding a building to agree to let you install your machines. From there, you simply have to service them occasionally to keep them running and periodically stop by to collect your coins.
It’s not a bad gig, and it’s one you can delegate to employees relatively easily. You may need to pay your salespeople a residual commission to sweeten the deal and get them hustling for you, though.
10. Residual Sales Income
Some sales jobs pay ongoing, residual commissions, not just a one-time commission. You bring in a client once but keep getting paid as long as that client stays with the company.
For example, some life insurance salespeople are paid both an initial commission on a sale and a percentage of the policy’s monthly premium every month that the client pays until the policy ends.
Although you probably shouldn’t choose your career based on the commission structure, residual commissions do create passive income for some salespeople. In some cases, salespeople only earn residual commissions for as long as they continue working for the company. But other companies keep paying residual commissions even after employees leave, giving them a runway for an easy landing in retirement or for entering a new career.
Annuities pay out a certain amount of money every month, usually until you kick the proverbial bucket. They serve as a floor for your retirement income, providing insurance against running out of money before you die
If you buy an immediate annuity, the payments to you begin — you guessed it — immediately. More often, you have to wait a certain number of years to start receiving regular annuity income.
Annuities are complex financial products you should review carefully before buying. Talk to several financial advisors before deciding to purchase one, and only consider annuities one component of a broader retirement income strategy.
In the film “About a Boy,” the protagonist lives off the royalties from a Christmas song his father wrote decades earlier. Amusingly, he hates the song that has enabled him to live without working for his entire adult life. But the example demonstrates the power of royalties, which keep on paying out as long as people keep buying your creative work.
In the art and entertainment world, book writers often receive royalties, as do musicians. Photographers and graphic artists can receive royalty income if their images sell through stock photography websites.
Royalties don’t come only from artistic works, though. Inventors and patent holders can earn royalties when other companies use their patented products or designs. Franchisees pay a form of royalties to the original franchise owner.
The list above is far from exhaustive. Technically, certificate of deposit accounts (CDs), money market accounts, and high-interest savings accounts all qualify as sources of passive income. But because they barely keep pace with inflation (if they keep pace all), many consider them more inflation-protection devices than sources of passive income.
Investing doesn’t have to revolve around the remote future, and retirement doesn’t have to wait until you find yourself humming “When I’m 64.” You can enjoy the fruits of investing right now by building an income portfolio while simultaneously laying the foundation for a wealthier future. You may just develop a passion for financial independence and plan your escape from the 9-to-5 lifestyle.
Do you currently invest for passive income? How? What are your goals for building passive income moving forward?
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