What is Passive Income? 5 Reasons Why It Reigns Supreme
Updated: Feb 21, 2020
This week’s article is all about an awesome little thing known as passive income.
Have you ever thought to yourself, “it sure would be nice if I could have some extra money or a way of having money come in every month without me working all the time…”
Okay… maybe you haven’t thought exactly that, but I think people start to wake up to the idea as they age and mature, some sooner than others, that we need to figure a way out of the rat race; we need to figure out how to stop trading in our valuable time for money.
"I used to think wealthy and successful people had these huge incomes from their job, like if they were a doctor or lawyer, or actor, that is how people got rich. It turns out that that is not true at all."
Bottom Line Up Front
Passive income is king. Passive income is the type of income that is produced from an asset requiring no work or active involvement. Alternatively, earned income requires work, or active involvement, like a job. In this article, I discuss the most common forms of passive income sources and then I deep dive into passive income, providing five reasons why passive income reigns supreme as an alternative to earned income and retirement savings.
Here’s a neat little story.
I had this thought last week and it made me chuckle to myself. I thought about how back in 2007 when I was a Sergeant (pay grade E-5), and I remember looking over the military pay chart and seeing the amount of money I could be making if I only stuck it out long enough and promoted up to the senior ranks (which I am now). I remember seeing those amounts. I don’t remember how much they were of course, but I remember thinking to myself that once I got to that level of income, I would be set. We could buy the house we wanted, a couple of nice cars, and stop worrying about money altogether.
The real problem that I wasn’t seeing was that I would still be trading in the same amount of time, if not more due to an increased level of responsibility. An increase in earned income is certainly a welcome thing, but if your job is just a job, and it isn’t something you're passionate about, I am convinced that it would take an objectively much larger amount of money to convince you that it actually makes a difference.
So, the fix that I was seeing at the time was striving for increased pay. The real solution that I wasn’t seeing was the elimination of trading in my valuable and finite time.
Common Passive Income Sources
Interest income, dividend income, royalties, rental income, and business income
This is not an exhaustive list by any means. I am only providing it here as a basic rundown to give the general reader a starting understanding of the most common forms of passive income.
Interest Income – Interest is income that is produced from loans, the same way a bank makes money off you for loaning you money for your home or your car. When you loan money to other individuals, companies, or governments, you are making interest income.
Peer to peer lending is common nowadays through services like LendingClub or Prosper. There are other less common methods of lending to individuals like promissory notes, where you can lend individuals money for business startup or funding as a private loan or private investor for something like a real estate investment.
Typically, lending to companies comes in the form of corporate bonds. Many times, companies need to raise capital and so will do it through issuing bonds, where people can purchase them. The company will pay a periodic amount based upon interest and terms of the bond.
Government bonds work the same way, except it is issued by the government. Typically, it pays periodic interest and the face value of the bond will be returned on the maturity date of the bond.
A less commonly thought of form of investment income is from high-yield savings accounts. Technically, when you are putting your money into a bank’s savings account, you are in effect letting them borrow your money, and so they pay you interest.
Dividend Income – Have you ever heard that phrase, “It’ll pay dividends?” When a company makes earnings, because shareholders have invested their own money into that company to leverage in operating their business, they will typically take earnings and give a portion to investors as an incentive to keep their money invested, as opposed to cashing out and moving on to something else.
Royalties – This type of income is derived from products that you provide others to use. Most notably, musicians receive royalties when their original work is used in other media content. Other examples here might include the use of various assets such as franchises, or other copyright material.
Rental Income – Rental income is simply the income you receive from tenants that live in a rental property that you own or a business that rents a location to operate their business.
This one holds a special place in my heart. I love real estate, especially residential real estate. I love it for the same reason Warren Buffet loves investing in Coca-Cola or Apple. It’s because I am passionate about real estate as an investment vehicle.
For me though, residential real estate is so unique because it isn’t about the investment itself, or about the dollars it deals with or produces. It is about the people. Real estate is about people and always will be.
A home is so crucial to each and every one of us, and we become so deeply connected with our homes, making lasting emotional connections that it becomes part of our personal nostalgia, which becomes apparent when we return to our childhood neighborhood and see our childhood home. It can bring us back and transport us to a different time.
There are other investment vehicles for producing rental income as opposed to just outright purchasing real estate to rent out. There are Real Estate Investment Trusts or REITs, pronounced “reet”. A REIT is a company that owns and manages properties, renting them out to tenants, typically in commercial settings. They produce their equity to purchase these properties through investors like us but take their cut to continue to run their business.
A final mention of rental income is house hacking. It is worth mentioning because I think it’s a cool concept. Basically, you can purchase a residence to be used as your primary residence (where you’ll live), and then you can rent out a portion of it
Commonly, people will purchase a duplex and live there, and rent out the other unit that they also own in the duplex deal. It will either pay for itself or mostly pay for itself, allowing you to live there for ridiculously cheap or nearly free. Some people access the FHA loan, or even better, the VA loan, and can put no money to little money down, and then live in a place for almost free or little money.
Business Income – This may not be passive income but can become a passive income. Running a business is certainly not passive, but owning one is. Once the business is established, a business owner can hire somebody to manage it for them and allow that business to continue to bring in income.
So, does passive income truly reign supreme? Is it really vastly superior to earned income and a better solution than retirement savings? Let’s take a look.
5 Reasons Why Passive Income Reigns Supreme
Reason 1: It is mathematically impossible to beat passive income
Have you noticed one common denominator in all the aforementioned passive income sources? Well, if you haven’t caught on yet, it is that they all require none to little of your own time to make the dollars come into your pocket. This simple little fact causes passive income to be superior to earned income. We can even break it down mathematically to see how much better it is.
We’ll use the equation for a percentage change. Change = (New Value/Old Value) x 100 – 100
If you want to read a bit more about it and nerd out, you can go to this article at mathisfun.com.
Example A: If a teenager works at a fast-food restaurant, and he makes $7.25 an hour, but then he gets a raise of $1.00 an hour, his new hourly wage would be $8.25. 8.25/7.25 = 1.137931. Multiply that number by 100 and subtract 100 and that’s your percentage. 13.7931%, or rounded, 13.8%. This is a wage increase of about 13.8%. That’s not bad.
Example B: A dance teacher gets paid to teach children ballet at a dance studio and charges $25 per hour. After she develops her reputation, she increases her rate to $30 per hour. The same math applies here. This is a wage increase of 20%. That’s superior compared to the increase of example A.
Example C: A real estate investor purchases a rental property for $100,000 with a capitalization rate of 8%. (This means that the house when rented out will produce 8% of $100,000 per year). That 8% capitalization rate produces $8,000 per year. Now let’s say his normal salary from his day job produces $50,000 a year. You could hypothetically say that his salary increase was 16% because it changed from $50,000 to $58,000 if you took his combined total income from both the earned income and passive income.
… but wait. How does that show how example C (the passive income example) is superior?! Hold your horses and keep reading!
Let’s take all three people from all three examples. Assume that they all stopped working for whatever reason. I’m not trying to get into semantics here, but just for the sake of example, they all stop working. The individuals from example A and example B make zero dollars. The individual from example C makes $8,000 per year. If you did the math, do you know how much that $8,000 a year in hourly wage is? Neither do I and neither does any calculator in the world because it's undefined. The individual in example C mathematically makes $8,000 per zero hours of work… or 8000 divided by zero.
I know you might be thinking that $8,000 a year isn’t very much. However, if that individual has been able to purchase 10 properties like this one over a 20 to 30-year period, they would have $80,000 in passive income. That’s incredible.
Now, I know there are a lot more intricacies like inflation, or if local markets go into decline. The point is simple math points out how passive income streams can produce excellent results for doing literally no work, and that clearly shows that passive income reigns supreme over earned income.
Reason 2: Time – The Great Equalizer
It is important to remember that there is one asset all of us are given the same amount. We are given 24 hours in a day and that is it, nothing more and nothing less. Bill Carmody authored this pretty amazing article about it, and how he calls it the great equalizer of life. In it, he talks about the difference between the mildly successful and the ultra-successful.
I’m not too concerned with ultra-success. What I personally draw from that article is that we are using up our chips, each worth 24 hours, and we use one up every single day. None of us can outrun the inevitable.
So, why aren’t more of us focused on looking for a way out of the rat race? Well, if you answered that you never want to get out of the rate race, do you know for a fact that you will never be so injured that you can’t return to work? What about if you are the sole provider, and you croak (God forbid) and your spouse who has been staying at home, and has no career to speak of, is left alone to raise the kids?
These are certainly tough questions, but they are impossible to answer adequately without passive income because that is the beauty of passive income. It doesn’t require you to trade in your time chips for money. Heck, it doesn’t even require you to have a heartbeat as long as it's in your will to whoever gets the proceeds…
Reason 3: It makes us more enterprising
I mentioned “The Rate Race” before. Robert Kiyosaki talks about it in his book Rich Dad Poor Dad, which is a fantastic read. I know there are some skeptics about Mr. Kiyosaki himself, but you truly can’t deny how powerful the ideas in that book are.
Well, he speaks about the rat race as how we are stuck in this daily and never-ending routine of having to go to work and trade our time in for money. I think that’s a reoccurring theme by now.
But what financial independence and movements like the FIRE movement produce, or as I like to call it, the SWFF (swift) movement, is that they produce in us an enterprising or entrepreneurial nature. The word enterprising is defined as having or showing initiative and resourcefulness. Similar words are imaginative, ingenious, inventive, original, creative, audacious, courageous, intrepid, and so on.
Dave Ramsey talks about it too, and it is why he believes that people should pay off their primary homes as soon as possible in what he calls Dave Ramsey’s 7 Baby Steps. Even though I don’t think that this applies to everybody, he recommends it to the common person because of this freedom from debt, as it changes a person’s psyche. When you don’t have that huge burden of debt on your shoulders, you walk a bit taller. You see things differently at work.
It causes you to think the following to yourself: “So what if I get laid off? I’ve got my emergency cash, some passive income coming in, no significant bills to speak of, and I’ve got all these incredible ideas that I want to pursue. I can start that podcast I’ve always wanted to do. I can get my real estate license like I was thinking about for years. I can make little trinkets and sell them on Etsy.” And so on and so forth…
At the time of this writing, I am still currently serving on active duty, but in a few more years, I will be eligible to retire with another stream of passive income from military retirement. Understanding that I will have this as well as a few homes providing passive income gives me incredible anticipation and a bright outlook for my future, as I will have far more flexibility to pursue rich and fulfilling settled work.
Reason 4: Rich people do it
I know, this reason sounds a bit funny. Have you, or anybody you’ve known, had a disdain for wealthy people? Why is/was that? It probably comes from the misconception or myth that most millionaires are lucky or that they inherited their money or something like that. The fact of the matter is though if we had somebody that we looked up to, wouldn’t we try to emulate them?
Just like a good parent, we grow up and try to be like them, or a good teacher at school, or an older sibling who you looked up to, or Mr. Rogers, or Mother Teresa. We look up to these people and want to emulate their goodness as a person. What about accumulating wealth? Well, if rich people do it, so should we.
Since we are all allotted the same amount of time and we can’t trade more time in for more money, it becomes obvious and apparent that wealthy and successful people find and build multiple streams of income. This doesn’t mean getting as many jobs as humanly possible. These other streams of income should come from things that don’t take up your time, and that’s how wealthy people end up doing it.
I used to think wealthy and successful people had these huge incomes from their job like if they were a doctor or lawyer, or actor, that is how people got rich. It turns out that that is not true at all. Tom Corley describes in his study called Rich Habits that 65 percent of wealthy individuals had three streams of income, 45 percent had four streams of income and 29 percent had five or more streams of income. Most wealthy individuals have multiple streams of income.
Reason 5: Passive income is superior to retirement savings
I’m not opposed to retirement savings by any means. I am a big believer in diversification. I don’t purchase individual stocks anymore, mainly because I don’t have the passion to study and deeply understand the financials of public companies and then invest in them. I would effectively be speculating as I have done in the past, and it showed.
So, when it comes to retirement savings, I’m all in on passive vehicles. I allow my money to ride the indexes. I leverage IRA vehicles like the ones that USAA provides or like Wealthfront or Betterment.
But these retirement savings vehicles aren’t where I am putting all my chips. I want to invest my time and money into investments that will bring me revenue, passive income, that will be lasting, and potentially never-ending, creating generational wealth. An IRA or 401k is finite. If there isn’t enough, eventually it’ll run dry, since you’ll be taking from it as you need it, if it hasn’t achieved enough financial gravity.
Passive incomes are superior in that the money is coming in indefinitely. It is paying dividends, rent checks, royalties, and interest, and you aren’t tapping into the root of those trees as you are with an IRA or 401k.
Passive income streams such as interest-paying loans, dividend-paying stocks, royalties, and rent checks, are vastly superior to earned income and traditional retirement savings.
We have gotten used to this idea that retirement savings are calculated by how much you expect that you’ll need and multiply it by the number of years you believe to be retired before passing away. This model is certainly flawed as we should be aiming for a certain level of income and looking to have it developed and produced from passive income streams.
The Woke Hack
“If you don't find a way to make money while you sleep, you will work until you die.” - Warren Buffet
Time to Pay it Forward
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