Passive income has become an overused cliche, thanks to overzealous internet marketers. There’s a lot of backlash out there against the idea that you can laze around on the beach as money flows into your bank account. Forbes has gone so far as to call passive income “a dangerous fantasy”.
The problem is this disillusioned view of passive income is it defines passive income so narrowly as to render it useless. Obviously you can’t create passive income by just putting up a bad website in a few days and letting it run completely on its own for years after that.
But passive income, as money that you regularly earn without having to put in much maintenance work, totally exists. There’s even a Wikipedia page about it. It’s not some new, earth-shattering idea.
In fact, most people are working towards building a kind passive income
It’s called retirement savings.
What is retirement savings, really, if not a way to make sure that Future You will have enough money without having to work? Only instead of having something that produces regular income, Future You will have enough cash stashed away to last decades.
Passive income in the form of retirement savings
With retirement savings, you can generally expect to put in 40 years of work to ensure that you’ll have 30 years of “passive income”.
When you retire, you might have to put in some effort into choosing the right investment vehicle, talking to your financial planner, dealing with the bank, etc. Or if you’re a low-maintenance saver, you might simply follow Warren Buffett’s advice to put your money in index funds. Either way, you probably wouldn’t spend more than a couple of hours a year on such maintenance work.
May I direct your attention now to Diagram 1?
I imagine the meaning would be immediately obvious from this excellently drawn diagram alone, but let me explain regardless. :D
The blocks under the Income column represents the income you earn from working and the shaded areas are the portions that you save for retirement. (Check out these articles for tips to save money.)
These shaded areas make up the big block of savings under the Savings heading. When you retire, you’ll (hopefully) have this block of retirement savings to spend. Whenever you withdraw money in retirement, you remove a chunk of the block, so it becomes smaller and smaller over the years.
Passive income from assets
While they’re both designed to cover your expenses without you having to work, income-producing assets work quite differently from retirement savings.
Let’s look at Diagram 2.
Again, there are shaded areas in your income blocks to represent the portions you save. But instead of leaving the money alone in a savings account, you turn it into income-producing assets. See how the asset blocks are shaded differently from the savings ones? ;)
Let’s say that, after accumulating enough money, you decide to use it to buy a rental property. You fix it up and rent it out, then you start getting rent income every month from your tenant. And because you’re always traveling, you hire a property manager to deal with the tenant’s needs. Voilà: passive income.
In the diagram, the timeline that extends from the asset block represents your annual cash flow.
When your first rental property is stable, you start focusing on saving up to buy another one. This time, the saving part doesn’t take as long because you have both your income from work and the rent income from your first property. Additionally, you’ve learned a lot when you bought your first rental property, so you actually know what to do this time.
If you repeat this frequently enough, soon you’ll have multiple sources of passive income. Your passive income might grow so much that it exceeds your working income, at which point you can quit your job and not feel much impact on your finances.
At retirement, instead of a chunk of savings, you’ll have a lot of assets that produce income. And as long as you can live on passive income alone, you’ll never have to reduce the size of your assets block.
Sources of passive income
Some sources of passive income:
- Rental properties
- Dividends from stocks
- Copyrights and royalties from your own songs, books, etc.
- Interest from loans
- Income from a business that doesn’t need much active input from you
- Recurring commissions from customer referrals (eg. network marketing, affiliate marketing)
Again, despite being called “passive”, all these income sources require a lot of hard work to build in the early stages. And even after they start stabilizing, they will need a bit of maintenance work from time to time.
For example, you may have to repair your rental property, adjust your stock portfolio or appear at book signing events.
So no, the income won’t be completely hands-free, but it will be as close to passive as you can get.
I have simplified things here
The truth is there’s a lot more to passive income than I can ever hope to cover in a blog post.
For starters, obviously you don’t only get four paychecks over your lifetime like my diagram shows and that tiny retirement savings block I drew wouldn’t last 30 years (which actually is kinda like how things are in real life for many people).
And you may fail at your first couple of attempts at building passive income. You may even lose lots of money, especially in the early learning stages.
Or, on the contrary, you may not have to spend much money at all. You can set up a website for less than $100 if you want.
There’s a lot of room for creativity when it comes to how to build passive income
It can be confusing, but it can also be freeing. You can choose to work on something that excites you. After all, whatever it is, you’ll spend a lot of time and effort on it, at least at first.
So much for “passive”, huh? ;)