Gone are the days of thirty year careers and an anti-climatic send-off with a gold watch. Increased labor competition, an economy shifting away from manufacturing and towards service, and a basic impatience from Generations X and Y have just about done away with the idea of retiring on a pension from a working lifetime with one employer. Add the Enron fiasco to the mix and most people have given up on the idea of “job security.” With all the uncertainty, creating multiple streams of passive income is a great way to hedge against the risk of unemployment.
A Shift in Thinking About Earnings
To fully appreciate the idea of passive income, one must shift their previously held assumptions on earning income. Most people, myself included, think of earning money as something we get in exchange for some amount of work. In its most basic form that is a pretty good definition of “earnings.” Some people refer to this as “dollars for hours” thinking. However, the part about exchanging some amount of work, or life energy, is not necessarily a requirement in the income-earning equation.
Passive income refers to income that is generated without any (or very little) additional effort on our part. Some effort may be put in up front, but the payoff from passive income can last for years. A few examples of opportunities to earn a passive income are:
Royalties on books. Royalties represent passive income in that the author of the work puts in all the work up front, but does not have to do much work to continue to receive payment for his or her work (with the exception of self-promotion, etc.).
Real Estate. Passive income from real estate can be derived in two ways, primarily. Homeowners may choose to rent out their property in which case the rental income is mostly passive, although basic landlord duties do require time to manage. The appreciation of real estate also has a networth increasing effect without requiring any additional work from the homeowner.
Interest. Interest income is passive income in that it does not require any additional work on the part of the recipient. The money invested may have been earned through work, but the residual interest and dividends received is passive income.
Why is Passive Income Important?
Every dollar you earn in passive income is a dollar you didn’t have to earn by working. In this way, passive income puts you closer to financial independence, a stage of life where you no longer have to sell hours for dollars in order to earn an income. A simple example assumes you have $1,000 saved in an interest-bearing account earning 3% (the current interest rate on ING Direct’s Orange Savings Account). Over the course of a month that $1,000 capital is working to earn you roughly $2.50 in passive income. If you had $100,000 in that same account it would bring $250 in passive income each month. Of course, money parked in investments earning an even higher yield, such as CDs, would bring in even more monthly interest income.
At this rate, it wouldn’t take long to earn enough in interest alone to cover your basic life expenses, especially if these earnings are reinvested (or compounded) until income from the fund is required.
How are you creating a passive income?