Oct 15, 2008

What is Passive Income and Why You Need It?

Passive income is the holy grail of personal finance. Passive income gives you more freedom than ever before. Passive income is what you should be striving for.

But what is it and where do you find it?

First thing's first. Let's look at some history.

'Swapping Hours for Money'

Sleeping like a baby
Photo: chris_gin

Whether you're in a full-time job, part-time job, temping or contracting you're essentially doing one thing and that one thing is what has been happening for centuries. You're swapping hours worked for money. Yes, call it 'compensation' or something else fancy but essentially you're swapping one for the other and that's it. It's that simple.

Income = Hours worked * Your rate per hour

Of course, what you get in return - your rate - is generally based on your skills and experience. The more skill and the more experience you have, the more you're likely to be paid per hour worked. Hopefully over the years, we get better at what we do and we are rewarded with a pay-rise.

The Problem with this System

Even though the majority of people go through their entire working lives doing this exact thing there is one huge drawback to this system. Consider the fact that the market conditions mean that what you can charge per hour is limited by what someone will pay. Even if you're lucky and you get into the top 10% or even the top 1% of earners the amount you can charge per hour is limited.

Therefore, if you want to increase the left hand side you have to increase the time component. No! I didn't think so either, you already work enough. This essentially means we've got a problem. You can't change your rate (much) and there are only so many hours in the day.

24 to be exact.

And you don't even want to be working a third of those either (if you include the weekends).

Can you see the problem now? Yes, you might get lucky and earn $1,000/hour which would be pretty sweet but in reality that's not going to happen. So what can you do to ensure you can get an increased income?

Change the Equation!

As stated earlier, both of the elements on the right-hand side of the equation are problematic. Your rate is a problem and the amount of time is a problem. What's the lowest common denominator of both of these elements? That's right. You.

Your time and your skills and experience.

The answer therefore is to remove yourself from the equation. This leaves the equation we stated earlier in tatters so we have to look at it through a fresh pair of eyes and change the equation. We're starting from scratch and what we have now is something like this:

Income = ?

So what we really want is something whereby we (most probably) have to do a little work up front but we can reap the rewards for that work for a long time to come. At regular intervals.

Essentially what we're doing here is making sure that this new income - Passive Income - is money given to you but for which you're not a part of it. i.e. you don't even have to lift a finger and if you do, it's only very slight.

How Can I Get My Hands on Passive Income?

There are a number of options. The main ones you'd traditionally see are:

  • interest earned from your bank accounts
  • rental money from real estate
  • stocks and shares which pay dividends
  • royalties from music, a book or other published work

Of course, we also live in an electronic world now and one in which there are many more ways to generate passive income. Think about some of these (usually placed onto a site you own):

  • selling your photos
  • affiliate programs, like AdSense, Amazon
  • creating and selling eBooks
  • selling user-generated works, like CafePress
  • having 3rd party adverts on your site
  • selling adverts directly

The list goes on and as you can see, there are some things which look a little complicated. Rest assured though, once you start generating this income without having to do much work towards it, you'll start to see how it can really help.

My Plan

Currently I own a house and am renting it out. This generates passive income for me though I must admit to having to do bits and pieces here and there. Another advantage is that I can also claim tax back on various aspects of owning it but renting it out.

At the moment, the house is definitely something which gives me an advantage, though I will certainly be playing with some of the new electronic ways of generating passive income. At the moment, I have a job so as well as swapping my time, skills and experience for money I can also go to bed safe in the knowledge that whilst I am sleeping, I am still earning money.

What are your Passive Income strategies? Are you looking at starting, or expanding, what you currently get?

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6 comments:

mythsnmagic said...

Well, you've definitely got me thinking about this! Ebooks? Maybe? My photos aren't interesting enough to sell, I don't think. Hmm, how about blogging???

retire-at-40 said...

@mythsnmagic:

Blogging? Absolutely. There are so many ways of generating passive income via blogging that it's worth a whole post in itself.

For starters, the 2nd half of the 2nd list can all be used. Have a look at some other blogs which do this and you'll see what I mean.

mythsnmagic said...

Thanks! I've made a start this morning - I know I have to upgrade out of wordpress.com to set up things like an Amazon bookstore, etc, but here it is theroadtohobbiton.wordpress.com

PizzaForADream said...

I think a combination of traditional forms of passive income and online forms is the best course in today's volatile economy. If looking for cashflow, you might try vending. We've gone from knowing nothing about the industry to becoming up and coming pioneers in just a couple of years.

retire-at-40 said...

@pizzaforadream:

You're dead right and that's the way it should be in all aspects of personal finance - diversification.

Not keeping all your eggs in one basket will probably do you well in the long run.

Maria said...

My passive income comes from a variety of sources. While most are online (niche sites, ebook, eHow, Bukisa, affiliate sales); I also have a rental property that rents for more per month than the cost of the mortgage and taxes.

My goal is ot have a full-time income coming in from online sources before I turn 30 ... I won't retire, but I will enjoy more time with my family and go on extended trips with educational and cultural opportunities. With residual income from online sources, you can live anywhere!