Do you earn income without actively working for it? For example, you might receive royalties from a song you wrote or rental payments from an apartment you own. If so, you receive what we call a “Passive Income.”
This type of income contrasts with active income. For example, if you work as a pilot and receive a salary from an airline, you are paid for your work—flying airplanes. This is called “active income.”
A major shareholder of the airline that employs you receives dividends each year. Dividends are payments made by a company to its shareholders, typically derived from its profits. This is an example of passive income, as the shareholder earns money without actively working for it.
The Motley Fool says the following about the term:
“Imagine if you could earn money simply by sitting back and doing nothing. Believe it or not, it’s something countless folks do every day. That money you earn with little to no effort is known as passive income, and it puts you on the fast track to financial independence.”
Unlike active income, which we earn through direct work or services, passive income often continues to flow in even after the initial effort has been made.
An example of initial effort is writing and performing a song multiple times before you begin receiving royalties year after year.
If you are a landlord who receives rental payments, your initial effort likely was to buy the property, furnish it, and make sure it was up to standard.
Passive income is a popular concept for individuals seeking financial freedom or additional income streams without constantly trading time for money.
If you want to improve your financial situation, it is important to learn as much as possible about passive income, including its benefits, risks, and various types.
Characteristics of Passive Income
Let’s take a look at some of the characteristics:
- Low Ongoing Effort
Passive income typically does not require daily work or constant attention. You may have to put in some upfront effort or investment, but your goal is to establish a system that generates revenue with little or no maintenance.
- Regular Earnings
Royalties, for example, are typically paid annually, rental income is often paid monthly, and some online platforms provide daily payouts.
- Scalability
Scalability means the ability of a business or system to grow and handle increased demand without losing efficiency.
Creating a digital product, such as an e-book or online course, involves one-time effort but can generate unlimited sales over time, making it a scalable source of income.
- Diverse Sources
Your passive income may come from various avenues, such as investments, royalties, automated businesses, rental properties, affiliate marketing, or peer-to-peer lending, to name a few.
Diversifying reduces risk and increases your earning potential.
Examples
There are many different types of passive income. Below are some common ones:
- Rental Income
Renting out a house, apartment, room, or commercial space is a popular way to generate passive income.
However, rental income is not entirely passive, as you may need to handle maintenance, collect overdue payments, and deal with other problems related to your tenant or property.
- Dividends from Investments
As mentioned earlier, being a shareholder and receiving dividends is a popular way to earn passive income.
It is important to choose the right shares. If you are not familiar with the business world or stock markets, consider consulting an expert before making a purchase.
Bear in mind that if the company does not make a profit, it is unlikely to pay dividends.
- Peer-to-Peer Lending
With an online platform, you can lend money to people or small businesses. You earn interest on the money you lend.
This option is not without risks; if your borrower defaults, you could end up making a loss.
- Royalties from Creative Work
Writers, musicians, and artists often earn royalties from their creations if they are popular.
In an article published by Far Out magazine, Lucy Harbron wrote the following about former Beatles musician Paul McCartney:
“Paul McCartney is one of the most successful musicians in history. It’s estimated that he earns $70million every year through royalties alone across his solo, Beatles and Wings discographies, merchandise, song rights, and more.”
- Digital Products
You can sell digital products such as software, online courses, templates, music tracks, stock photos, and e-books. Once the initial effort of creating the product is complete, you can enjoy ongoing financial returns with minimal additional work.
Affiliate marketing involves promoting someone else’s product through your website in exchange for a commission on sales.
This strategy is particularly popular among website owners with high traffic, such as well-known bloggers or influencers.
It’s a low-risk, scalable model commonly used in digital marketing.
- Real Estate Investment Trusts (REITs)
Our Financial Glossary says the following about REITs:
“A real estate investment trust (REIT) is a company that owns and typically operates a portfolio of real estate properties and mortgages. REITs allow investors to earn a share of the income that is generated through the ownership of commercial real estate – without the need to actually buy any commercial real estate.”
- High-Interest Savings Accounts or Certificates of Deposit (CDs)
While traditional savings accounts offer modest returns, some high-interest accounts or CDs provide a way to earn passive income through interest.
Benefits of Passive Income
Here are some reasons why you should consider pursuing a passive income stream:
- Financial Freedom or Independence
It reduces your reliance on an active income, providing you with more freedom to pursue other interests.
- Stability
It acts as a safety net, especially during periods of job loss or economic uncertainty.
However, some income streams may be affected by economic recessions or changes in the central bank’s monetary policies.
Even the shares of blue chip companies are not 100% secure.
- Wealth Building
By reinvesting passive income, you can grow your wealth over time.
- Flexibility
With a passive income stream, you can choose where, when, and how much to work, giving you more time to enjoy life.
Challenges and Misconceptions
Like anything in life, there are also some challenges:
- Initial Effort or Investment
Most passive income streams require significant upfront work, investment, or expertise.
Paul McCartney, for example, worked hard writing songs and then performing before he started earning royalties.
- Risks
Every investment carries risk, and passive income streams are no exception.
- Not Always Immediate
Establishing a reliable source of passive income can take time and patience.
- How passive is each income stream
A common misconception is that passive income is entirely “hands-off.” While it requires less effort than active income, some level of management or monitoring is often necessary.
How to Start Earning Passive Income
Here are steps to begin your passive income journey:
- Evaluate Your Resources
Assess your time, skills, and financial situation to determine which income stream suits you.
- Research Opportunities
Learn about different options and their potential returns and risks. In other words, find out as much as you can about each potential income stream – do your homework!
- Start Small
Begin with one income stream before diversifying. In this case, ‘baby steps’ are the best way to go.
- Monitor and Adjust
It is important to regularly review your investments or strategies. Make adjustments as needed to ensure you achieve the best possible ROI (return on investment).
Conclusion
Passive income is a powerful financial tool that can help you achieve greater freedom and stability. Whether through investments, rental properties, or creative endeavors, there are numerous ways you can build passive income streams.
Most of us, as we grow older, aim to retire and rely entirely on a pension, which is itself a form of passive income.