Going to work every day and getting a paycheck every two weeks? That’s active income.
Freelance work and side gigs? Those are active income, too.
Being self-employed? Still active income.
Active income is money that you have to work in order to earn, on an ongoing basis. It’s trading hours for dollars.
Passive income is money that you earn while you’re sleeping. Or playing with your kids. Or relaxing on the beach, playing golf, sipping a nice cabernet or doing whatever it is you’d rather do than work.
It’s money that comes in without you having to work for it. Sounds pretty terrific, right?
What Are Common Forms of Passive Income?
Passive income comes in many shapes in sizes, but four are far more common than the rest.
The first is dividends from stocks. Stocks tend to be better vehicles for appreciation than income, but some do produce yield in the form of regular dividends.
Another investment that produces passive income is bonds. You effectively lend your money, then get paid back with interest. Bonds tend to make better investments when interest rates are high (which they haven’t been in this century).
Passive income can also be created by starting a business, then letting others manage it. Business owners must still keep an eye on the business’s direction however, if they want it to survive and thrive in the long term.
And, of course, there’s rental income from investment properties.
These aren’t the only four types of passive income of course. You can earn passive income from
- royalties from songs, books, art, and other creative works more of us should be putting out into the world
- peer-to-peer loans (on the lending side, of course! But you can also borrow peer-to-peer money to buy rental properties)
- crowdfunding services (likewise)
- vending machines, laundromats, and other semi-automated income sources (which, by the way, landlords and property managers do to leverage to earn more from their rentals… just saying)
Or any number of other investment vehicles. But the basic pattern remains: you invest a great deal of money, time, or both, and gradually you increase your passive income.
Passive income requires more work than active income… at first.
Why Isn’t Everyone Out Creating Passive Income?
They are, sort of. When people save and invest for retirement, their nest egg usually includes stocks that pay dividends, and perhaps bonds. Retirement income is passive income.
But retirement is a distant, nebulous idea for most people. It’s something they do because everyone tells them they “should,” not because they’re trying to build passive income to change their life here and now.
The other answer is that passive income takes a great deal of work up front. It requires investment of time and/or money, with no immediate results.
See all that time put in, before the money starts coming in?
Yeah… that’s just not what most people are all about.
Mindset Shift: Thinking About Time & Money Differently
That graph above looks nothing like the normal relationship between time and money. For most people, it’s a 1:1 correlation: for every hour they work, they get a certain amount of money.
Let’s use another of Paula’s fun hand-drawn graphs, shall we?
This is how most of us think about money. Our parents raised us to think this way”
“If you do more chores you’ll earn more money.”
And then our first five jobs reinforced this message:
“If you pick up the Saturday shift you’ll earn more money.”
We talk about this at length in how parents can raise their kids to be good entrepreneurs, rather than good employees. It starts with teaching your kids to think differently about money.
Now, your parents probably raised you with the traditional “time = money” mindset. Passive income is about breaking out of that mindset, and thinking like this:
“If I spend the next 60 days scouting for potential rental investments, making offers, settling on a property, and placing a good long-term tenant in my new rental, I’ll earn $400/month in income for the rest of my life.”
See how that works on the first graph? Time, money, and effort up front, followed by stopping work but continuing to earn money.
“What about that point on the graph where I should stop working?”
Glad you asked. Once you have a great tenant in the property, there are a few things you should occasionally be doing, to keep your good tenants happy and continuing to rent from you. But that doesn’t mean you should be showing up at the property every weekend, hammer and drill in hand, asking the tenant “What do you want done this weekend?”
Know the expression “diminishing returns”? Yeah, it applies here.
But here’s where you can continue to see better results: in stacking up more passive income streams.
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Free Mini-Course: Passive Income from Rentals
Passive Income Can Be Stacked
One of the many problems with active income is that it comes with a limit: your time. You can only work so many hours in a given week.
There’s no such limit on passive income. You can own as many stocks or bonds or rental properties as you can afford, and every asset owned makes it that much easier to buy the next one.
Thus, you can stack forms of passive income up indefinitely. Ever hear the expression “The first million is the hardest”? Passive income is precisely why. As you build wealth and assets, more of your income comes from passive investments, rather than active work. Your income increasingly becomes independent from your work, and the sky’s the limit on how much you can earn when your income is untethered from your time.
“So you’re saying I put in a flurry of work & money on one passive income stream, let that start earning money, then put in another flurry of work & money on the next, and just keep going like that forever?”
No one said forever.
Personal finance geeks (like me!) love to talk about financial independence. Financial independence means that your living expenses can be covered entirely be your passive income, so you are no longer dependent on a job or active income in order to pay your bills.
“Okay, so I put in some work & money to buy a property that earns me $400/month, take a breather, do it again, until I have enough to cover my bills? Then I can stop?”
Sure, if you want. But the only way you can stop is if your expenses stay fixed, while your passive income rises.
Avoid Lifestyle Inflation
When the average person suddenly finds themselves with more money in their pocket, what do they do?
They spend it.
As you start seeing the results of efforts like house hacking, it’s crucial that you set aside all the savings for investments. That’s the whole point, after all: building passive income to replace your active income.
After a year of having no housing payment, all the money you would have spent on housing will total a hefty sum. You can use that money to buy another investment property, or buy stocks, or bonds, or any other investment that generates passive income.
One of the problems with lifestyle inflation is that the greater your expenses, the more money you need to replace with passive income. Retirement planners often talk about the 25X Rule, that your nest egg should be at least 25 times your annual spending. That means that every $1,200/year you spend, that’s $30,000 more you need in your nest egg.
Think about that for a second – every $100/month extra that you spend, you need another $30,000 in savings.
This is why you need to be careful to avoid lifestyle inflation. Every dollar you spend is another dollar you’re not investing, and another $25 that you need to invest.
First Steps to Building Passive Income
Passive income does require work and money up front. That means it starts with saving money – and lots of it – and putting in extra time outside of your 9-5 job.
What would it take to live on half your income? Suspend disbelief and try identifying areas where you can could save 3% here, 5% there.
Most people spend 70% of their income on just three expenses: housing, transportation, and food.
Because housing is the most expensive, start by asking “How can I reduce or eliminate my housing expenses?”
You could move into a less expensive home, of course. But that’s not very creative.
A slightly more creative answer is to rent out a room in your home to a housemate. Even better, you could segment off part of your home to be self-contained, and rent it either short-term (e.g. on Airbnb) or long-term as an income suite.
For a truly powerful solution, you could “house hack” a multifamily property. This form of house hacking involves buying a multi-unit building, moving into one of the units, and leasing out the other(s) to pay the mortgage, repairs, and other housing expenses. If you don’t think it’s possible, read how one ordinary insurance underwriter house hacked with a suburban duplex.
Start thinking about your “escape the rat race” number. How much passive income do you need, to cover your monthly expenses?
In other words, what will it take to reach financial independence?
Find ways to spend less and funnel more money toward your passive income investments. Start investing in dividend-paying stocks and rental properties. Take our free mini-course on passive income from rentals.
Because the alternative is continuing to run on the financial treadmill, working hard every month only to stay in the same place.
Do you want to spend the rest of your life trading hours for dollars? If your priority is driving a fancy SUV, going on regular shopping sprees, eating out frequently, etc., there’s nothing wrong with that, but understand that it comes at a cost. You will likely have to keep working, and for a long time to come, because your lifestyle is expensive.
If your priority is freedom from being tied to a job, understand that it too comes at a cost. You will need to keep your lifestyle in check while you devote large portions of your income to investing, and you will need to invest some time and work up front to create passive income earlier than just a retirement nest egg.
Ashley and Kevin Thompson reached financial independence in six years, all while traveling the world. At first it took an incredible amount of discipline, living on a fraction of their income. Later, it got easier, as they started earning more and more passive income from their rental properties. Today they have $40,000/year in passive income from their rentals, and growing.
What would your life look like, if your income were no longer tied to your work?
What to Do Now:
- Say out loud right now: “Is my priority continuing to live the exact same lifestyle I’m living, or is it to build wealth and passive income, to reach financial independence?” Then answer the question honestly. Say the answer out loud, and decide if you truly believe in it or not. If your priority is building wealth and passive income, write a recurring note on your calendar to remind you of your priorities.
- Take our free mini-course on building passive income from rentals.
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