You hop on a flight to Brazil or Costa Rica or Thailand. You spend a month reveling in the sand and surf. You taste new foods. You discover new music. You spot wildlife you’ve never imagined.
You don’t check email the entire time. Heck, you don’t even post photos to Facebook. You’re radically offline — like it’s 1972.
You return to the U.S., check your bank account, and notice your balance has grown while you’ve been away. You’ve returned from your month-long trip with more money than you had when you started.
Sound like a fantasy?
This can be your life — if you create self-sustaining passive income.
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Passive Who? What’s Passive Income?
If you’re not familiar with passive income, let’s start this article by rocking the definition:
“Passive income” is money that flows into your pocket while you’re sleeping. Or eating cake. Or eating cake while sleeping (a Nobel-worthy achievement in its own right).
When you’re collecting passive income, your money is grossly disproportionate to the hours or minutes you work. Actually, “disproportionate” isn’t the right term: it’s un-proportionate. Your income loses correlation to your hours.
At any other job, regardless of your income level, there’s a relationship between time and money. “Active income” requires a time-for-money trade.
Active income is the status quo of the default world, and you can hear echoes of this in everyday conversation:
I charge $230 per hour.
He makes $78,600 per year.
She earns $4,250 per month.
These statements reflect a link between time and money. The more hours you log at the office (or the home office), the more money you make.
(Yeah, I hand-drew this graph. Long live MS Paint!)
Passive income shatters this association — as it should.
Time is limited; money is infinite. Time is precious and in short supply; money is abundant. It makes no sense to trade time for money; it’s unsustainable.
“Sounds great in theory, Paula. But I need to pay the bills.”
Of course. Unless you’re Paris Hilton or the offspring of a Real Housewife, you’re forced to trade time-for-money in the beginning — but this is a stepping stone. Trading time-for-money is a temporary condition, not a permanent one.
Unless you’d like to keep trading time-for-money forever?
Yeah, I didn’t think so.
Your current wages/salary are the training wheels on your first bike. They’re the handrail you grasp while you’re learning to walk. They’re the analogies you exhaust when you’re writing articles. (Wait, what?)
“Great. So if I want to create passive income — I just snap my fingers, and voila, it appears?”
Nice try, buddy, but no.
Creating passive income involves swallowing a rough pill that the Conformist Majority despises: you’ll need to embrace upfront work, in exchange for self-sustaining riches down the road. Ramp up, so later you can ramp down. Front-load your workload.
Passive income isn’t “something-for-nothing.” This ain’t the lottery, and it’s not a get-rich-quick scheme. You’ll be planting seeds today, so you can harvest freedom for the rest of your life.
“What are some examples of passive income?”
Great question. A few examples include:
- Rental income from properties that other people manage and repair
- Royalties from books, music and other creative works
- Income from businesses you own but don’t operate
- Owning vending machines, laundromats, arcade games and other hands-off entreprises with one or two employees
- Peer-to-peer lending
- Dividends from stocks and ETFs
- REITs and other income-oriented market investments
- Bonds and bond ladders
“Paula, don’t be silly. Nobody plays arcade games anymore.”
Back to the original point:
- If you have $2 million lying around, and you invest in stocks with a 4 percent dividend payout, you’ll make a cool $80,000 per year in passive income.
- If you’re the Rolling Stones, that track that you recorded for (I Can’t Get No) Satisfaction creates passive income every month, even though you recorded it years ago.
- If you’re Miley Cyrus at age 58, you’re still collecting royalties for … (actually, we’re just going to end this sentence here.)
Real estate is my primary passive income tool (owing to my flagrant lack of guitar and twerking skills).
Because I’ve built my freedom from real estate, I tend to focus my conversation and content in this area, but this isn’t meant to denigrate the other avenues listed above. Everything within those bullet points are fantastic roads for creating self-sustaining wealth and freedom. They all have their own timelines, of course, and each carries its own risk profile — but sooner or later, they’ll all get the job done.
“But real estate isn’t passive, is it? You have to buy the house, and that takes work …”
I get this question all the time. To answer it as best I can, I drew a graph of how the real estate experience plays out:
Check out the lower-left-hand piece of the graph, which shows the start of the adventure.
In the beginning, you invest time (and some money) but don’t earn any immediate income. This feels like the worst of both worlds, and this is why the vast majority of people — the Conformists — shy away from passive income investments.
(The Conformists, unsurprisingly, are also stuck in 9-to-5 jobs for 40+ years. The key word is “stuck.” They’re not choosing to work because they love their job. They’re forced to work to buy groceries.)
Let’s assume that you decide to build passive income through rental property investing.
At the start of the game, you’re:
- Reading and learning about investments and businesses
- Hunting for properties
- Analyzing deals
- Negotiating and closing deals
- Renovating and repairing properties
- Building your team — hiring property managers, contractors and other support staff. This is the most important step if you want to scale, a lesson I learned the hard way. You don’t want to be getting calls about broken toilets. Hire someone to take those calls on your behalf. (If you’re just starting out, and you choose to field those calls yourself, pay yourself for your time. Never confuse “investor profit,” which is passive, with “manager pay,” which is active. If you bought a McDonalds franchise, you wouldn’t stand at the cash register, would you?)
After a few months of front-loading your workload, you rent the property, and BAM — the hard work pays off. You get your first rental deposit. Cha-ching!
At this point, you’ve experienced two phases:
- Active: Work, but no income. Your Conformist friends think you’re nuts.
- Passive: Income, even though it’s been weeks since you last did a shred of work on this project. Your Conformist friends are envious. “Oh, it must be nice,” they gush.
At this point, you have two choices:
- Option A: Kick back and enjoy the fruits of your labor.You’ve finished the upfront work, built systems, hired a team to run your business, and now the checks are rolling in. Passive income will flow into your bank account, with little-to-no input from you (less than 1 hour per week), for the next 15-20 years, until it’s time to remodel the property. Several decades in the future, you’ll spend about 3-6 weeks overseeing a renovation, and then you’ll kick back and enjoy the passive gains for the next 15-20 years.
- Option B: Squeeze more juice from this orange (er, “optimize your investment,” in boring parlance). Embrace optional work that can bump your rental prices and stick even more money into your pocket. Temporarily revert back to “active” work so that you can enjoy even more passive income for the next two decades.
If you choose Option B — and remember, it’s a choice — you’re playing in the space on the graph between the two dotted lines. You’re in the space where the x-axis, representing time, starts moving horizontally again, while our payout, the y-axis, also grows in lockstep.
At this point, we’re doing things like:
- Swapping out an “okay” fixture for a “wow” centerpiece
- Staging the unit with furniture and fresh flowers, for an impressive showing
- Snapping amazing Pinterest-worthy photos of the rental unit
- Writing a damn good advertisement for Craigslist.
Here’s an example of the optional kitchen upgrade we gave House #5.
At the time that we bought House #5, I didn’t plan on upgrading the kitchen — and frankly, I didn’t need to. I could have left the original kitchen intact.
But I wanted to squeeze more juice from the orange. After analyzing the local market more closely, I knew a kitchen facelift could increase prospects and lower vacancies, ballooning the bottom line. This work was optional, but I chose it because I knew that a few weeks of work will create tens of thousands of additional dollars that sustains for 15-20+ years into the future.
The Difference Between Active and Passive
Here’s another example:
If I spend 30 minutes crafting an ultra-compelling Craigslist posting for one of my rental units, I might slice one month off my vacancy rate (for an extra $900) plus snag an extra $50 per month ($600 per year) in rent. Over the span of the year, this could create an extra $1,500 for 30 minutes of work.
Since I can re-use that same posting at every turnover (or better yet, send it to my property manager, who will re-use that awesome posting at every turnover), that 30 minutes of work can generate an extra $1,500 every year, in perpetuity.
Sure, those 30 minutes are optional income — represented by the space between those two dotted lines on the graph — but the workload is marginal and the payout is enormous.
But — and here’s the but —
Let’s say that I take that to its logical extreme. Let’s imagine that I spend 100x time, 50 hours, crafting some amazing Craigslist posting. That would be ridiculous. I wouldn’t get a return on my time. I’m not going to rent the space 100x faster, nor will I collect an extra $5,000 per month. In other words, the relationship between time and money disappears.
This is the point on the graph where you really oughta stop working. You’ve juiced the orange to its max. Additional work won’t yield additional income. Your biggest return-on-time comes upfront, and it actually pays to NOT devote too much more time to the endeavor. That’s right, it makes economic sense to stop working and enjoy your life.
Check out this point on the graph — everything to the right of the dotted line. Money stays high (the y-axis). It doesn’t drop or decline. The time investment is behind you (everything left of the second dotted line). In fact, putting in more hours is counterproductive. Its time to kick back and enjoy the money flowing in.
Contrast this with the traditional employment model, in which you charge by the hour or year. Even if you’re well-paid, earning $100 per hour or $100,000+ per year, there’s a direct correlation between the hours you work and the money you make. Work 10 times the hours (or work for 10 years), and you’ll get 10 times the pay.
Quit your job — and the paychecks stop coming. That’s scary.
The time-for-money trade is also limited by the number of hours you can work. You have 168 hours per week, and every hour you devote to working is an hour you can’t spend making guacamole and drinking pineapple juice.
Passive income, by contrast, is unlimited. Once you’ve wrapped up one project, you can move onto the next — and wealth starts to pile.
That’s the ultimate difference between active and passive income. Active income rewards you for endlessly trading time-for-money. Passive income rewards you for working hard today so you can reap the rewards for decades into the future.
I want to answer a question I’ve been hearing from a lot of readers recently: “How do I begin? I’d like to create passive income. How do I start?”
This article is already nearly 2,000 words long, so I’m going to save that answer for Part II, which you can read here. Enjoy!