Extra income while you sleep
Imagine waking up each morning to find extra cash in your savings account, freeing you to read, travel, and spend time with your family.
Or you could use that money to pay off your credit card. Or save for a new house. That is the power of passive income.
So, what exactly is this type of revenue stream?
Passive income is a regular flow of money that requires little ongoing time and effort to earn. In contrast, active income is earned through performing a service – for example, the wages from a regular day job.
Passive income investments are a great way to secure financial independence. A passive income source can give you the financial freedom to pursue your passion projects – and might even help you retire early!
Let's dive in and look at some common passive income ideas.
How to generate passive income
There are several ways to earn a passive income stream, including dividend income from shares, interest from fixed-income investments, and rental income from real estate investments.
Passive income from dividend shares
Investing directly in high-quality dividend stocks only takes a small amount of initial research and can be a great way to earn passive income, particularly over the long term.
Dividend shares generate passive income by paying out a percentage of the company's profits to investors, usually twice yearly. High-quality dividend stocks are great set-and-forget passive income investments because they provide a regular cash flow in the form of dividend income.
If you want to buy dividend stocks as part of a passive income strategy, always look for companies with a high dividend yield. The yield shows how much a share pays out as dividends each year as a percentage of its stock price.
Suppose you also select companies that are growing their earnings per share (EPS). In that case, you can enjoy a growing income stream from your dividend-paying shares that can supplement your existing active income streams, like the money you receive as a salary from your day job.
Alternatively, you can reinvest your dividends to buy more dividend stocks, thereby compounding your passive income stream for future use – perhaps in retirement, for example, when you won't receive work income.
A bonus of dividend income is the ability to earn franking credits, reducing the tax an investor must pay at tax time.
Need help deciding which dividend shares to buy? No problem! Dividend-focused exchange-traded funds (ETFs) can spread even a tiny investment across many different dividend-paying shares in various industries, which also helps to lower risk through diversification.
Passive income from bonds (fixed interest)
Bonds are a type of debt that companies or governments can use to fund projects. When you buy bonds, you effectively lend money to the bond issuer. In return for borrowing your money, the issuer (a company or government) pays you regular fixed-interest payments called coupon payments, which are your passive income.
It's much like a regular loan, where the lender (usually a bank or other financial institution) receives steady interest income from the borrower, determined by the interest rate charged on the loan.
The interest payments on bonds are generally lower than returns on dividend shares, but they also come with less risk due to the predictability of the return.
Additionally, if a company goes bankrupt, the bondholders stand near the front of the creditors' queue to be paid back, ahead of the shareholders.
You can invest in bonds through big investment brokers or an exchange-traded fund holding a basket of different bonds.
As with shares, an ETF can be a great way to spread your investment across multiple bonds so you don't have all your eggs in one basket.
ETFs also make it easy to reinvest your interest payments to grow and compound your passive income over time.
Are investment properties a passive income investment?
Investment properties can provide a great source of cash flow through weekly or monthly rental income from tenants. But is this passive income?
The challenges
Managing an investment property can be like running a small business if you do it yourself. You need to maintain and protect the rental property, and you also need to find and manage the tenants. If your idea of earning passive income is relaxing at the beach uninterrupted, then real estate investing might not be your best option.
Instead, you can always hire a professional property manager to look after your investment property. This option takes the day-to-day hassle out of running your rental property, as your manager will liaise with your tenants, arrange repairs, and collect the rental income on your behalf.
It means you can finally put your feet up and enjoy the financial freedom of owning your investment property, right? Well, that depends on how much rental income you hope to earn.
The money trickling into your savings account may be less than you had hoped, considering most property managers typically shave off 5%-10% of your rental income as their management fee.
Buying an investment property can also be very expensive.
The opportunities
However, an alternative passive income idea is to rent out part of your existing home if you can't afford the hefty cash deposit required to buy an investment property (usually 20% of the purchase price). This can still give you extra rental income without all the hassle of managing an investment property.
Renting out space, like a spare room, on platforms such as Airbnb or Stayz allows you to generate extra cash from an asset you already own. However, you must research and understand the tax implications of capital gains before going ahead.
Another way to earn passive income from real estate is to buy shares in a real estate investment trust (REIT) on the stock market. Your rental returns are delivered to you as distributions (a different name for dividends relating to funds), usually paid quarterly.
The beauty of a REIT is it can give investors access to other forms of property investments that typically wouldn't be available to the average person, such as commercial and industrial real estate.
In addition, a REIT usually offers diversification across many investment properties in a single transaction.
What are some other passive income ideas?
Peer-to-peer lending is where you lend money to other people directly through an online platform in exchange for interest income.
Peer-to-peer lending offers higher returns than bank term deposits because the loans tend to come with more risk (so the interest rate is usually higher). The loans are typically unsecured, and there is little protection for the investor/lender if the borrower decides to disappear into the night.
Think outside the box
So far, most of the passive income ideas we have discussed have involved using financial assets to generate passive income.
But if you're just starting out with little money or are creative and willing to invest some time, there are other great ways to earn passive income.
Many passive income ideas require some time and effort to set up, but once that's out of the way, they can provide an ongoing extra income stream.
For example, you could write and self-publish a book (or ebook) and earn passive income from the ongoing sales. Or you could get paid for your love of photography by licensing your original photographs to stock photography websites and earning royalties.
If you're savvy with social media and have built up an online following, you could earn income from YouTube views, submitting videos on Snapchat, or through affiliate marketing programs from your blog or website.
Affiliate marketing is an arrangement between you and a company. You can earn a commission if someone buys one of the company's products or signs up for an account or newsletter by clicking through your website to the company's website.
Start early
Building a portfolio of passive income can be fun and highly rewarding. The key is getting started early, as time is vital in successful long-term investing.
While these passive income ideas may not generate immense wealth overnight, the earlier you start, the more time you will have to grow your passive income from a trickle into a raging river.
Frequently Asked Questions
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You must declare any money made from passive income sources (like share dividends or rental income from investment properties) to the tax office, as it will form part of your taxable income for the year. This is something to consider, especially if your additional passive income pushes you into a higher marginal tax bracket.
However, some passive income sources also provide tax benefits. For example, dividends from ASX companies often come with franking credits attached, which you can use as a tax deduction at tax time. Or, take the often-debated practice of negative gearing. When the income you earn from an asset (typically the rental income from an investment property) isn't sufficient to cover your associated expenses (like the interest repayments on your mortgage), you will make a loss on that investment. Through negative gearing, you can use this loss to offset your other taxable income and decrease your tax burden.
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We often associate passive income streams with financial assets, like shares, bonds and other investments. While these are some of the easiest and most popular ways to earn passive income, they can also be expensive to purchase.
However, plenty of other ways to earn passive income don't require significant upfront costs. If you have the time and energy to invest in a project, you can create passive income streams with little to no money. For example, you could self-publish an ebook online or sell your photos to stock image websites. Or, if you have a large social media following, you could generate commission income from affiliate marketing schemes.
In other words, you don't need a heap of money to start up a passive income stream. Just use your imagination and leverage your strengths!
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Here at the Fool, our favourite source of passive income is share dividends. It's the easiest and quickest way for everyday investors to start generating passive income streams.
We believe a portfolio of high-quality dividend stocks is the best 'set and forget' investment out there. It doesn't take long to set up, can be tailored to suit your investing needs and risk appetite, and requires little ongoing maintenance.
You can also choose between taking your dividends as cash or reinvesting them into buying even more dividend-paying shares. Reinvesting your dividends allows you to compound your returns over time. Compounding is one of the most sure-fire ways to build your long-term wealth.
Not only that, but ASX dividend stocks also often come with juicy franking credits. These can help reduce the tax you must pay yearly on your other income.
