How Passive Income Works
Passive income is any money you earn on a regular basis that doesn’t come from a job. In some cases, passive income is money you get from a project or investment that you put money or time into at the start. For example, if you own part of a business but are not actively involved in running that business, your cut of the profits is passive income.
You can also earn passive income from a project that you’ve invested your time in, rather than your money. For instance, if you spend a year writing a book the royalty payments you get from that book’s sales are a form of passive income.
Having a source of income that doesn’t require the day to day grind can offer some unique benefits including :
- Extra Cash. When you’re short of money, financial experts usually advise you to respond by tightening your belt. Little luxuries, such as a daily latte or cable TV, are usually the first expenses to be slashed from the budget in an effort to make ends meet. But if you can find a way to supplement your regular paycheck with a passive income stream, the extra income can allow you to enjoy these simple pleasures again without going into debt.
- A Cushion for Emergencies. Many Americans live paycheck to paycheck, with no savings to fall back on in an emergency. The Federal Reserve’s annual report on the economic health of households found that 47% of Americans couldn’t easily come up with an extra $400 to cover an unexpected expense, such as a car repair or a trip to the emergency room. A passive income stream could give you the extra cash needed to build up an emergency fund without having to cut back on your current spending.
- More Job Flexibility. When your job is your only source of income, you’re dependent on it. You’ll put up with unpleasant working conditions or unreasonable demands from a boss, because giving up your job would leave you with nothing to live on. But if you have some passive income to fall back on, you can afford to be a little picky in your selection. If you don’t like your current job, you can afford to ditch it for a new one that pays less, eking out your lower paycheck with passive income. And if you lose your job altogether, you’ll still have at least a little income to hold you over until you find a new one.
- Extra Money in Retirement. The vast majority of Americans aren’t putting aside enough money to support themselves comfortably in retirement. If you’re in this position, you could one day find yourself with no income except for Social Security, which was never designed to be a family’s sole source of support – and which might have to cut its benefit levels still further before you reach retirement age. But if you do the work now to create a passive income stream, you’ll have some additional money coming in (in addition to Social Security checks) after you retire.
- An Earlier Retirement. If you can earn enough passive income – from one stream or, better yet, from several – it can replace your paycheck altogether, making you financially independent. This would give you the option of retiring early, or perhaps quitting your current job and taking up a new career that interests you. Making this much money solely from passive income doesn’t happen overnight – but it is possible.
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Ways to Earn Passive Income
When you see the phrase “passive income” in an article, it’s often referring to money earned from passive income investments, such as dividend-yielding stocks or real estate. However, investing is one of many ways to earn income when you’re not working. There are a variety of other ways to set up a passive income stream by putting in an initial investment of time, money, or both – and there are even a few that don’t take very much of either.
1. Real Estate
One of the best-known ways to earn passive income is through real estate. Renting out a building can bring in a tidy sum of money each month, with little work in some cases – but it can also require a big chunk of cash up front to buy the property. There are also low and no money down options but these can bring on more risk, and many people recommend the traditional route when first getting started.
Though it can take a while to build up enough cash to put a 20% down payment on an investment property (the typical lender minimum), they can snowball fairly quickly. The key here is to correctly project income and expenses in order to calculate cash flow. However you have to be sure to include the cost of a property manager in your calculations unless you want to manage the property yourself. Even with a property manager, you may be required to make large repair decisions every now and then – so while this is not a 100% passive activity there are completely passive options with real estate investing.
Many buy and hold investors (ie rental property investors) take that excess cash flow and put it toward their next down payment. This allows them to slowly amass portfolios of dozens and sometimes hundreds of rental properties.
Investing in real estate can be very profitable and mostly passive. However, a lot of people don’t want to deal with owning a physical property where they need to deal with tenants and property mangers.
Another option for passively investing in real estate is through a real estate investment trust (REIT). REIT’s own multiple real estate properties and allow investors to invest in the portfolio. The great thing about an REIT is that there is a 90% distribution rule. Each REIT is required to pay out 90% of their net income as a dividend to investors.
One of my favorite places to invest in REIT’s is through Fundrise. They have a historical return of 8.7 – 12.4%. Plus, you can invest with as little as $500.
Investing in REIT stocks can also be a great way to make passive income. It requires an upfront investment, but once you’ve done your research and found solid companies with high dividend yields, you can sit back and collect the dividend checks (or reinvest the dividend earnings).
2. Residual Sales Income
Typically, when you work in sales, you earn your money in the form of commissions. Every time you sell a product or a service, you are paid a percentage of the money paid by the customer. With some types of sales jobs, however, you don’t just earn a single commission when you make a sale – you also receive ongoing residual payments from sales you’ve made in the past. This type of residual income that can last for years after the original purchase.
Products and services that sometimes pay their salespeople this way include:
- Insurance. Say you’re an insurance salesperson who has just sold a 10-year term life insurance policy. You earn a one-time commission for making the sale, but you also earn a percentage of the monthly premium every time the buyer pays it. So long as the insured keeps making those monthly payments, you can keep collecting residuals off that one sale for up to 10 years.
- Financial Products. Certain types of financial products, such as annuities, also pay ongoing commissions to the professionals who sell them. Financial advisor Ethan Braid of High Pass Asset Management writes that when he sells a $500,000 annuity, he not only earns a 7% commission, or $35,000, immediately – but on top of that, he gets a 1% “trailer commission,” or $5,000, every year the buyer owns the annuity. So a financial advisor who has sold 10 annuities that are still active could bring in an income of $50,000 a year just from these trailer commissions.
- Service Contracts. It is sometimes possible to earn residuals for products or services with pay-as-you-go contracts, such as home security services. If a client signs a contract to have his or her home monitored for a monthly fee, the salesperson can receive a residual payment each month the client pays for this service. Furthermore, agreements often pay monthly residuals to sales employees. For example, alarm companies selling ongoing home or business monitoring for a monthly fee may offer residual income to those who sell this service.
No type of sales job can be considered truly passive. In fact, sales can be more active than most jobs, since your pay often depends on how much you sell, and it takes plenty of hustle to bring new customers on board. However, if you’re already working in sales, or considering it as a career, it could be useful to focus on products that can bring in residual income in addition to the usual commission. That way, you can continue earning money on work you’ve already done.