You've probably heard the term ‘passive income'. But what does it actually mean? And how is it different from ‘active income'?
Give me a few minutes, and you'll know exactly what it is & why it's important for you to know.
Income comes in a few forms: active, passive, or residual. Passive income, also known as passive income streams, is one form of income that doesn't require much involvement to generate, it is a reliable source of internal profit, it forms the foundation for prospective residual income, and it just might be the key to financial success.
The Expenses Problem
At the early stages of your journey to financial freedom, something will become very clear very soon.
There's a limit to how much you can cut
One of the first steps in financial freedom is tracking what your expenses are, and which ones of those are absolutely necessary, and which ones aren't.
At some point, you'll only be left with expenses that are vital for survival, and you can't cut down on those. Cause, you know, eviction, hunger, debt collectors, repo men & women and the like. Not a fun party.
If we were to take this situation, and assuming one line item in your sheet of expenses is still dollar cost averaging into low cost index funds, you'll find that, in most cases, you still have a long way to go before you can FIRE yourself.
We're also assuming that you currently only have 1 income source, either from traditional (un-)employment or self-employment. Forms of active income.
Since you can't cut down anymore on your expenses, we need to look at increasing your income.
The Problem with Increasing Your Income
You already have a job, or your already self-employed, so where the heck are you going to find the time for another job that'll bring in more income?
I've already alluded to it, but the form of income most of people have is active income.
What is Active Income?
Active income is income that comes from active work.
For some reason, I always like to use the analogy of Sarah, a massage therapist.
Traditionally Employed & Active Income
Sarah is employed as a massage therapist and is paid an hourly wage of $20, which is almost the median US hourly wage according to the Bureau of Labor Statistics (Source)
Assuming a full-time 40-hour work week, Sarah makes $800 per week.
With me, so far?
Now, what happens when Sarah is ill or is on vacation? (And assuming she has no more PTO or sick days, which apparently you can run out of in the US).
If Sarah is ill for 3 8-hour days, she misses out on $480.
5 days would be $800. 10 days would be $1600. 30 days would be $4800.
These are not just numbers on a screen for Sarah. This is her livelihood. This is her income.
Can you see how Sarah's time is directly tied to the hours she does or doesn't work?
1 hour not put in = no $20 in wages earned.
Let's imagine for a second that Sarah is some kind of superwoman. She never gets tired, she never goes hungry, she never has to drink, she never has to take bathroom breaks, or even sleep. (Sounds a lot like the robots ‘taking our jobs')
In this robotic state, Sarah is effectively able to work 24 hours all 7 days of the week.
Of course, Sarah sees her income increasing significantly.
Taking that same $20 hourly wage, she's now earning $480/day or $3360/week.
And there it is again. A ceiling.
Even in this unrealistic simulation, where our Sarah is able to work 24/7, there is still a cap on how much she can earn.
She can negotiate a raise, and it can go anyplace, but the fact will always remain: her income is capped.
Because her time is still directly tied to how many hours she's able to put in
Self-employment & Active Income
Our massage therapist Sarah goes out on her own and starts her own massage salon.
She redecorates a room in her house to function as her new office.
Because being self-employed comes with several other expenses, she now charges $50/hour. Of course, Sarah is very skilled, so she has no problem finding new clients, and has a healthy stream of repeat clients.
Sarah is able to decide her own schedule as she pleases. Because she has no other big commitments, she opens her practice 10 hours a day.
This means that her potential daily income is $500.
But, again, and the same as when she was still traditionally employed, there's a cap.
Even if robot-Sarah were to work 24/7, the most she'd ever be able to make is $8400 per week.
But wait, there's more!
Now, because she's her own boss, Sarah doesn't operate in a dynamic of PTO or sick days anymore.
Meaning that, if Sarah wanted to take a vacation, or is unable to work due to illness…she's not generating an income.
An hour not put in still has a direct impact on her income.
Her time is still directly tied to the amount of money she makes.
The employed and self-employed are on the left side of the Cashflow Quadrant. And that left side is only active income.
The Passive Income Side of the Cashflow Quadrant
Now, on the right side of that Cashflow Quadrant is the passive income.
The type of income that is not tied to how many hours you put in.
Literally making money while you sleep and thus, sustainably solving the issue we had of needing additional income source, or multiple income sources.
Some Examples of Passive Income
Some passive income examples to drive the point home, are easiest to understand, and you're already familiar with.
While writing this I'm listening to a song on Spotify. The artist didn't have to wake up, fly here, set up the instruments, and start singing in order for me to hear that song. The song was released, and each listen earns the artist income.
You probably know of Harry Potter? Whether you've seen the movies, read the books, or neither of those things – you know that that whole franchise is popular and has people buying books, toys, games, movie tickets and so much more.
This all started with JK Rowling, the author and creator of Harry Potter.
Although it seemingly was a difficult road for her to get the book published, it eventually did. In 1997. Almost 30 years ago.
Yet, if I were to go on Amazon now and buy that 1st book, Rowling would still receive a cut from the purchase I made. Almost 30 years after it was published and put into the world!
Whether you like the show or not, you know of that sitcom ‘Friends', right?
It ran for 10 years (1994 – 2004 – so it's almost been off the air for 20 years), yet the 6 main actors are still making 7 figures every year. ($20 million total according to this report)
And then there's the more close-to-home example of a landlord collecting rent money.
Do you see how passive income is completely detached from the time you actually put in?
Now, on to some passive income ideas you may not have heard about, and ones that virtually anyone with access to the Internet can create:
- Rental income
- Royalty income
- Dividend investing
- Affiliate marketing
- Selling books on Amazon
- Selling digital products on Etsy, Shopify, WooCommerce, Squarespace, Gumroad, …
- Selling physical products on your own online store front, or leveraging Amazon FBA or Amazon Merch
- Starting a business (where you start and stay on the right side of the Cashflow Quadrant)
- Building digital assets (like your own YouTube channel, a themed Instagram account, your own blog)
- and there's so much more that you can do…
Risks of Passive Income
The concept of passive income, and the coin your income not being directly correlated to your time and the hours you put in also has another side to it.
When creating a passive income source, you will often be spending a lot of time and resources researching, creating, soft-launching, refining some more … all while you're not necessarily seeing any income from it. Yet.
This means that you could spend weeks, months, or even years putting the time into creating this new passive income source and it not being a financial success, or even run breakeven for you.
So, while the concept of passive income is simple, that does not mean it's also easy.
That's why whenever I go out and attempt to create another predictable, ideally monthly recurring, passive income stream, I keep my focus on projects that, should they fail, I've maybe lost only a couple of weeks.
And, even then, I don't really consider it ‘losing', since I've now found a way how this particular idea doesn't work for me right now.
Maybe it needed more capital. Maybe it needed more time. Maybe it needed less of something else. That's what the
loss experience will tell me.
Disclaimer: This post may contain affiliate links, which means that I may receive a commission if you make a purchase using one of these links, such as from the Amazon Associates program.