Passive income is a regular personal cashflow that requires very little ongoing time and effort to earn. This contrasts with active income you earn from performing a service or selling a product or even like the salary you earn from your regular day job. This is the simplistic approach to understanding passive income. So, now to digging a bit deeper.
There are several ways to earn a passive income stream, including dividend income from shares or ETFs (exchange traded funds), interest from fixed-income investments, rental income from real estate investments, distributions from REITs (real estate investment trusts), peer-to-peer lending, royalties and many, many other methods.
So, what are some types of passive income investments?
Passive Income From Dividend Shares
It only takes some standard initial research to successfully Invest directly in blue chip dividend growth stocks. This can be a great way to earn passive income, particularly over the long term. A steadily growing stream of dividends is as close as it gets to pure passive income.
I simple terms, dividend stocks generate passive income by paying out a percentage of the company’s profits to investors, usually twice per year. High-quality dividend growth stocks are great set-and-forget passive income investments because they provide a regular & reliable cash flow in the form of dividend income.
Essentially, when you own shares in high quality dividend paying companies, you are a part owner of that business and the dividends are your share of the profits. Nice!
If you want to buy dividend stocks as part of a passive income strategy, always look for blue chip companies with a steady growing stream of dividends. The yield percentage of a share shows how much a share pays out as dividends each year, as a percentage of its stock price.
Additionally, if you also select companies that are growing their earnings per share (EPS), you can benefit from a growing income stream from your shares that can supplement the money you receive as a salary from your day job.
It’s worth noting that you can reinvest your dividends to buy more dividend stocks, thereby compounding your passive income stream for future use – perhaps in retirement (or semi-retirement), for example, when you are no longer receiving active income from your salary.
Maybe you are not sure which individual dividend shares to buy? There is a solution for that ….. dividend-focused ETFs can spread any investment across many different dividend-paying shares in various industries, which also helps to lower risk through diversification. ETFs are such a simple product the buy and hold if you are time poor.
Passive Income From Bonds
Bonds (a fixed interest product) are a type of debt that companies or governments can use to fund projects or business growth. When you buy bonds, you effectively lend money to the bond issuer. In return for borrowing your money, the issuer (a company or government) pays you regular fixed interest payments called coupon payments. These coupon payments are your passive income.
This is much like a regular loan, where the lender receives steady interest income from the borrower, which is determined by the interest rate charged on the loan.
It is worth noting that the interest payments on bonds are generally lower than returns on dividend shares, but they also generally come with less risk due to the predictability of the return.
Normally, if a company goes bankrupt, the bondholders stand near the front of the creditors’ queue to be paid back, ahead of the shareholders. Hence why bonds are seen as having lower risk than individual company shares.
Investing in bonds can be done through big investment brokers or a bond ETF holding a basket of different bonds.
As with shares, an ETF can be a great way to spread your investment across multiple bonds, so you don’t have all your eggs in one basket. Some ETFs have a mixture of both shares and bonds which can create a single solution if that suits you.
ETFs also make it easy to reinvest your interest payments (received as distributions from the ETF) to grow and compound your passive income over time.
Is Investment Property Income Truly Passive?
Investment properties can provide a great source of cash flow through weekly or monthly rental income from tenants. But is this truly passive income? Let’s unpackage this a bit.
Managing an investment property is just like running a small hands-on business if you do it yourself. You need to maintain and protect the rental property and you also need to find and manage the tenants. If your idea of earning passive income is being minimally involved and being free, then real estate investing will not fit the bill very well at all.
As a solution, you would need to hire a professional property manager to look after your investment property. This takes the day-to-day hassle out of running your rental property, as your manager will liaise with your tenants, arrange repairs, and collect the rental income on your behalf. But it is not fool proof because you will still need to manage the property manager relationship and expectations. Additionally, property managers are a real cost that comes directly out of your profits and cashflow.
Does this mean you can finally kick back and enjoy the financial freedom of owning your investment property? Hmmm, that probably depends on how much net rental income you can realise from your properties. The rental money trickling into your savings account may not be as much as you thought it might be, considering most property managers typically shave off 5%-10% of your rental income as their management fee.
Buying an investment property can also be a very expensive, drawn-out process. If you can’t afford the hefty cash deposit required to buy an investment property (ideally 20% of the purchase price) and all the associated taxes and fees, an alternative passive income idea is to rent out part of your existing home. This can still give you extra rental income without all the hassle of managing an investment property.
Renting out space, like a spare room, on holiday rental platforms allows you to generate extra cash from an asset you already own. However, make sure you research and understand the tax and insurance implications before going ahead with this approach.
Another way to earn passive income from the real estate market is to buy shares in a REIT on the stock market. Your rental returns are delivered to you in the form of distributions (the correct term for dividends used in relation to funds), usually paid quarterly.
The beauty of a REIT is it can give investors access to other forms of property investments that typically wouldn’t be available to the average person, such as commercial and industrial real estate. Additionally, there is no tenants to manage, no insurance to worry about, no repairs to properties, no vacancy worries and no payments to property managers.
REITs are truly the most passive way to realise an income stream from real estate.
Importantly, a REIT usually offers huge diversification across many investment properties in a single transaction.
What Other Passive Income Ideas Exist?
Peer-to-peer lending (P2P) is where you lend money to other people directly through an online platform in exchange for interest income.
P2P lending offers higher returns than bank deposits /gilts / HISAs because the P2P loans tend to come with more risk (so the interest rate is usually higher). The loans are typically unsecured and there is little protection for the investor/lender if the borrower decides to disappear into the night. Some P2P platforms offer insurance funds against this event but not all.
Thus far, most of the passive income ideas we have mentioned have involved using financial assets to generate passive income, but if you’re just starting out with little money or are creative and willing to invest some time, there are other great ways to earn passive income.
All genuine passive income ideas require time and effort to set up, but once that’s out of the way, they can provide an ongoing extra income stream in the future.
For example, you could write and self-publish a book (or e-book) and earn passive income from the repeat sales. Or you could get paid for your love of photography by licensing your original photographs to stock photography websites and earning royalties.
If you’re clever with social media and have built up an online following, you could earn income from YouTube views, submitting videos on Snapchat, or through affiliate marketing programs from your blog or website.
Affiliate marketing is an arrangement between you and a company. You can earn a commission if someone buys one of the company’s products or signs up for an account or newsletter by clicking through your website to the company’s website.
Building a portfolio of passive income can be enjoyable and rewarding. The key is getting started early, as time is vital in successful long-term investing. While these passive income ideas may not generate significant overnight wealth, the earlier you start, the more time you will have to grow your passive income from a trickle into a waterfall.
Never underestimate the power of time and incremental sustainable growth in this arena.
Finally
Understanding passive income takes time and effort no matter what method you choose.
If passive income was easy to achieve, then everyone would be doing it with ease – but they’re not.
Do your research, align your goals and interests, know WHY you want/need passive income and go for it.
Essentially, passive income equals freedom – freedom of time to live the life you want to live.
