The idea of building wealth through passive income has understandable appeal, especially if you’re worried about being able to save enough from your work earnings to meet your retirement goals.
For example, to generate $1,000 a month in retirement income from a portfolio, you’d have to amass about $250,000, assuming a 5 percent withdrawal rate. Better to generate a stream of income using creative avenues.
What is passive income?
Passive income includes regular earnings from a source other than an employer or contractor. The IRS says passive income can come from just 2 sources: rental income or a business in which an individual does not actively participate. Examples include book royalties and dividend-paying stocks.
Investopedia defines passive income as “earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not actively involved.” Popular culture, however, defines it as “any money you earn while sitting on a beach sipping mojitos.”
Financial coach and expert Todd Tresidder thinks it falls somewhere between the two, defining passive income as the money you earn from a project or investment after you’ve made an initial contribution of time or money.
“Many people think that passive income is about getting something for nothing,” says Tresidder, founder of FinancialMentor.com, a financial coaching service. “It has a ‘get rich quick’ appeal … but in the end, it still involves work. You just give the work upfront.”
Untold thousands of people have tried to create fruitful passive-income streams only to be surprised by the amount of work, cash or time involved. So if you’re thinking about going down this road, check out the reality behind 5 types of passive-income strategies.
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Selling information products
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Some people fantasize about creating passive income by establishing some kind of information product — an e-book, CD, DVD — then kicking back while cash from the sales of these products rolls in. It’s often touted among Internet marketing gurus as an easy, surefire way to create a passive-income stream. But while information products can eventually yield an excellent income stream, Tresidder notes that it’s hardly a passive activity.
“It takes a massive amount of effort to create the product,” he says, “And to make good money from it, it has to be great. There’s no room for trash out there. It has to be something people are willing to talk about.”
Tresidder says to find financial success in selling information products, you must be committed to devoting a great deal of time, energy and money into the project at the outset. You have to build a strong platform, market your products like crazy and plan for serialization.
“One product is not a business unless you get really lucky,” says Tresidder. “The best way to sell an existing product is to create more excellent products.” But once you master the business model, he adds, you can generate a good income stream.
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Investing in rental properties is an effective and time-honored way of earning passive income. Nonetheless, it often requires more work than people expect. If you don’t spend the time learning how to make it a profitable venture, you could lose your investment and then some, says John Graves, author of “The 7% Solution: You Can Afford a Comfortable Retirement.”
To earn passive income from rental property, Graves says you must determine 3 things: the return on investment you want to have, the property’s costs and expenses, and the financial risks of owning the property.
For example, if your goal is to earn $10,000 a year in rental income and the property requires a $2,000 monthly mortgage plus an additional $300 a month in taxes and other expenses, you’d have to charge around $3,150 in rent monthly to reach your goal.
Now, the question becomes one of risk: Is there a market for your property? Might you get a deadbeat tenant? Will your tenant damage the property? All of these could result in a sizable dent in your passive income.
“You have to know your area and tenants really well,” says Graves. “If not, you could get crushed, and it would take years to recover.”
To many, affiliate marketing seems like an easy way to generate cash. Here’s how it works: Website owners or bloggers promote a third party’s product by including a link to the product on their site. When a visitor clicks on the link and makes a purchase from the third party, the site owner earns a commission, generally around 15% to 20%, according to StartupNation, a website for aspiring entrepreneurs.
Affiliate marketing is considered passive because, in theory, you can earn money just by adding the link to your site. In reality, you’ll earn squat if you don’t find a way to attract readers to your site, click on the link and buy something.
“It’s a long-term project,” says Joe Udo, owner of the website Retireby40.org. “If you’re just starting out, then it’s not going to be passive because you have to build traffic and generate content.”
Even after you’ve gained a steady following, for best results, you need to write content that draws attention to the product and link. “If I recommend something, I’ll usually write a blog post about it or add a link to another relevant post,” says Udo. “It’s best to recommend products that you like and believe in. You shouldn’t try to sell things that you have no experience with.”
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More investors are turning to peer-to-peer, or P2P, lending as a way of creating passive income. And for good reason: According to MarketWatch, annual returns for investors in Lending Club, the largest P2P lender in the U.S. market, average 5% to 9%, depending on the credit grade. But to achieve such returns, you can’t be as passive as you might wish.
A P2P loan is a personal loan made between you and a borrower, facilitated through a third-party intermediary such as Prosper.com or LendingClub.com. As a lender, you earn income via interest payments made on the loans, but because the loan is unsecured, you face the risk of default.
To cut that risk, you need to do 2 things: Diversify your lending portfolio by investing smaller amounts over multiple loans (Prosper.com recommends more than 100), and analyze the historical data on the borrowers to make the right picks, says Udo. For example, Udo has found that lending to those borrowing for home-improvement projects brings a lower default rate, as does lending to borrowers who haven’t sought loans elsewhere within the prior 6 months.
The time it takes to master the metrics isn’t the only reason P2P lending isn’t entirely passive. Because you’re investing in multiple loans, you need to pay close attention to payments received. “I get about $100 (in interest payments) every week that needs to be reinvested since I want it to accumulate interest,” says Udo. “I have to go back every week or two to reinvest. That takes time.”
Shareholders of dividend-yielding stocks receive a payment at regular intervals from the company’s profits or reserves. Since the income received from the stocks isn’t related to any activity other than the initial financial investment, owning dividend-yielding stocks can be one of the most passive forms of making money.
The tricky part, of course, is choosing the right stocks. Graves warns that too many novices jump into the market without thoroughly investigating the company issuing the stock. “You’ve got to investigate each company’s website and be comfortable with their financial statements,” Graves says. “You should spend 2 to 3 weeks investigating each company.”
That said, there are ways to invest in dividend-yielding stocks without spending too much of an initial time investment. Graves advises going with exchange-traded funds, or ETFs. ETFs are investment funds that hold assets such as stocks, commodities and bonds, but they trade like stocks.
“ETFs are an ideal choice for novices because they are easy to understand, highly liquid, inexpensive and have far better potential returns because of far lower costs than mutual funds,” says Graves.
Similarly, real estate investment trusts, or REITS, are a good choice for passive investors, although Graves warns that they’re pricey right now. “With REITs, you can do the research in a much shorter period of time,” says Graves. “Your level of understanding doesn’t have to be high to make a (sound) investment.”