When you're looking to provide for yourself and your family, your work is likely a primary income source. But having a job isn't the only way of earning money. While it will take foundational legwork and informed decisions, you can create a cash stream with passive income.
Let's discuss how to generate passive income, important factors to consider and how it can fit into your financial plan.
What is passive income and why would you need it?
Passive income is cash flow that comes to you with minimal ongoing effort or time commitment, unlike regular income that you earn from working. This type of income stream has become a sought-after goal for many people seeking financial freedom, flexibility and security. Knowing you can rely on that extra source of cash can help you reach your goals now and in the future.
Common ways to generate passive income
Whether you want a creative strategy or a tried-and-true method, many options exist for creating a sustainable stream of passive income. Note that for any of these options, you'll need sufficient savings to invest. Here's a look at some of the most popular methods:
Traditional securities and other financial tools like dividend stocks, index funds, exchange-traded funds (ETFs), bonds and certificates of deposit (CDs) can generate passive investment income. The interest from high-yield savings accounts also can be considered a form of passive income.
Dividend stocks.While any stock might pay a dividend, stocks referred to as dividend stocks have a track record of paying high and consistent dividends. These are often stock of large-value "blue chip" companies that are financially sound and have a good reputation. Yields may be 3% or much higher on some stocks, though higher yields may indicate higher risk. Bonds.Corporations and governments often borrow money by issuing bonds. Bonds are debt contracts that obligate the issuer to repay the borrowed principal plus interest. Purchasing bonds provides you with those interest payments and the return of principal at the bond’s maturity. Index fundsand ETFs.These are diversified and generally low-cost funds that invest in entire markets or segments like the S&P 500 or small-cap stocks. Due to market exposure, the income stream is less steady than other forms of investment income. You also can buy funds that exclusively purchase income-producing instruments like dividend stocks or bonds. CDs.Certificates of deposit are similar to bonds, but they're issued by banks to raise capital for loans and other services to customers. You agree to leave your money in the account for a fixed period of time, and after that time is up you'll receive a fixed rate of interest on your money. These are usually covered by FDIC insurance,making them a secure investment. Fixed annuities.Fixed-deferred annuities can be especially helpful for retirees looking for conservative passive income. They allow you to take advantage of a high interest rate environment with locked-in rates that are not impacted by market performance. You may want to consider a multi-year guaranteed annuity (MYGA), a type of fixed annuity designed to avoid market volatility and offer tax-deferred growth during a guaranteed period (which means waiting three or more years).
Rental properties can be a great way to build wealth and generate passive income. They're considered an asset-sharing type of passive income, as you're renting out something you own for someone else's use. It's a little different from owning financial assets because you can decide how involved you want to be. You may choose to collect rent, manage repairs and find tenants on your own or turn it over to a property manager.
While you can buy rental property outright if you have enough cash on hand, most people start out by borrowing to purchase properties. You could consider commercial property like a shopping center storefront, warehouse or office space. Or perhaps you're interested in residential properties—single-family homes or multifamily units. Some people keep their first home as a rental when they move into a bigger house to accommodate a growing family.
Residential rent contracts are often a year or longer, but short-term vacation rentals are another popular option.
Real estate investment trusts (REITs)
Rather than directly owning individual properties, you can invest in rentals through real estate investment trusts, or REITs. Think of these as real estate
You purchase an individual REIT on the stock market as you would other stocks. To feel confident in the company you choose, you'll want to do some research. REITs aren't typically an investment suited for tough economic times, either. While this can be a profitable choice, you may want to talk with a financial advisor about your overall investment goals.
Peer-to-peer lending lets you fund loans for other people. You can use third-party platforms to screen applications and connect with potential borrowers.
As a lender, you can decide which applicants you'll fund and whether you want to fund entire or partial loan requests. You can even diversify among multiple borrowers. Payments are usually made back to you in fixed monthly installments, providing a steady stream of income. As a peer-to-peer lender without the backing of a financial institution, you are taking on some risk—if the borrower doesn't pay you back, it's unlikely you'll be reimbursed.
Is one right for you?
Additional considerations on passive income
While sitting back and collecting passive income is the dream, you'll first want to feel confident that you're set up for success. Keep these important factors in mind as you consider different ways to make passive income:
Some forms of passive income, such as real estate, may require that you tie up your money for long periods of time. Money in high-yield savings accounts, on the other hand, is easily accessible. Consider how soon you may need your initial investment when choosing the best form of passive income for you.
All investments, even those that provide passive income, expose you to some amount of risk. Rentals sometimes lie vacant, index fund values fluctuate, bond prices fall if interest rates rise and corporations may cut dividends. That's just part of investing.
Make sure you're comfortable with the type and degree of risk associated with the passive income you're considering. A financial advisor can help you
The timing of your investment payouts should align with your cash flow needs. For example, some bonds pay all of their interest in one payment at maturity, while others make regular payments over the life of the bond. Any cash flow interval is fine as long as it matches your timeline. If you have a large purchase coming up, like funding your child's college education, plan accordingly so you have access to the cash you need.
Cost of doing business
There's often more to passive income generation than an initial investment. A classic example is the maintenance, repairs, taxes or management fees on rental properties. Ensure you feel financially and emotionally prepared for this kind of labor, especially if it's on top of a full-time job.
Any time you choose to invest in something, it means you have to forgo putting that money toward something else. That is called opportunity cost. Your passive investments could impact your other financial goals and when they're accomplished.
For instance, if you've been planning a larger donation to a local nonprofit or want to sponsor an ongoing project, you may need to balance that charitable goal with your passive income goal. If you put the charitable goal on hold to undertake a passive income project, perhaps that income can be earmarked for resuming your charitable goal once the steady steam starts coming in. It's not always a matter of one or the other, but rather when the income pays off.
New income will generate a new tax liability, and you'll need to stay on top of your own estimated tax payments since "passive" means there's no employer to withhold it. Talk to a financial advisor and your tax attorney to ensure your plan is
Solidify how passive income fits into your financial foundation
Before putting a passive income strategy into place, plan for how it fits into your broader financial goals:
Establish a budget.Knowing your income and expenses is an essential step toward effectively creating passive income. This allows you to responsibly identify where you can afford to put money toward passive income sources. Pay down debt. Reducing your debt leaves more room in your budget. You then can direct more of your current income toward passive income investments, while freeing up the income those investments generate. Instead of funding your debt, your passive income can fund you. Open an emergency fund. You need to have a source of funds for unexpected expenses, especially when assets may not be liquid, to pay for unexpected items. Things like insurance deductibles, home repairs or tenant requests may not always be part of a planned budget because people tend to think about monthly or recurring expenses. An emergency fund protects both your day-to-day finances and your passive income by putting enough money aside for the unplanned. With that safety net in place, you won't be forced to sell passive income investments if things get tight.
Talk through your passive income plan
Passive income can be a sound investment, giving you and your family more freedom to live the life you want now or tuck more away for a steady retirement.