Passive income comes in various shapes and forms depending on how and in what you dedicate your resources and time. The passive investment opportunities are many and diverse. This article seeks to give you some examples of different types of passive income and, thus, ideas to how you can start creating passive income.
How Passive is Passive Income?
While some people receive passive income from royalties by creating songs, books or movies others earn passive income online through investments they have made in stocks, bonds, real estate crowdfunding or P2P lending such as business lending, consumer lending and mortgage lending.
It is commonly assumed that earning a passive income implies doing the bare minimum and simply receiving money for a work that has already been done or an investment that has already been made. However amazing this sounds, it is not the exact truth, depending on your passive income strategies.
Sure, passive income earnings do free up your time to do more stuff, but in order to gain true financial freedom, there are some things you must see to, which we will have a closer look at in this article. We will also look at some of the best passive income investments within the world of P2P lending (also often referred to as crowdlending or social lending).
What is Passive Income?
Let us start by defining passive income and holding it up against its counterpart: non-passive income.
Passive income means an income derived from an activity in which a person is not involved, e.g. earnings derived from royalties, rental properties, limited partnerships, peer-to-peer lending, stocks, or others. In this case, “not involved” implies that those who benefit from these earnings are not actively involved. On the contrary, the income is earned passively (hence the term “passive income”) after the work or investment has been realized. In other words, this means that the person receiving the passive income does not have to lift a finger to earn financial benefits derived from a previous act.
Non-passive income, on the other hand, constitutes any active income, for instance, salaries or self-employed income. These incomes are not considered passive because people have to actively work in order to receive them. If no action is taken, no income will be received.
The famous American businessman and author Robert Kiyosaki talks about two different types of income called linear income and residual income. Employees and self-employed earn linear income because for these types of individuals time equals money – you either have a job or own a job, and you only get paid for the exact amount of hours you put into your work. On the contrary, business owners and investors earn residual income because they either have people or money working for them – you either own a system with people working for you or you simply own money that works for you. According to Robert Kiyosaki’s description, the only true way to come near true passive income is to become an investor that have footsoldiers (money) out in the field working for you.
How to Make Passive Income?
Are you interested in knowing more concrete ways to earn passive income? Below, you will be presented with some of the best ways to make passive income online.
As was pointed out earlier in this article, receiving a passive income is not the same as making money while you sleep; you cannot generate a substantial passive income unless you put at least some work, knowledge, and research into it. In that way, the word “passive” can be rather misleading.
In order to make passive income, you have to invest in an asset that will generate passive income on your behalf. Here are four popular ways to create passive income in 2020:
- Passive real estate investing (property shares & loan contracts)
- Passive income from ownership in big businesses (dividend stocks)
- Passive income from lending to big businesses or governments (bonds)
- Passive interest income from peer-to-peer lending (loan contracts)
These four types of passive income are some of the most common ways of creating passive income streams online right now. Below, this article will take you through each of the four passive income strategies.
Passive Real Estate Investing
One of the best and most efficient passive income strategies is real estate investing and, in this regard, real estate equity crowdfunding or real estate P2P lending for getting exposure to specific projects. For readers with millions to invest and enough money to buy their own property and hire a property administrator, you can skip to the next section – for everyone else interested in passive real estate investing, below are some interesting possibilities to explore.
For many years, real estate has been the most common source of passive income. However, it has mainly been carried out through rentals of homes, apartments, office spaces, etc. However, even though they all generate a sizable monthly revenue and investments in real estate seem like a really good source for generating automatic or passive income, it also requires:
- A relatively high upfront investment
- Quite a lot of ongoing work caused by being the landlord
Nowadays, potential investors seeking passive income earnings through real estate investments can find a great variety of crowdfunding marketplaces that offer high-quality real estate loans or co-ownership in large buildings through shares (equity). Except for choosing the deals, you do not have to actually do any of the heavy liftings yourself, compared to if you were the landlord renting out the property.
Real estate lending platforms such as EstateGuru and Bulkestate, to mention a few, have opened up for the world of real estate investment loans to not only include the most wealthy people in society; today it is possible to start investing in passive income property loans with as little as €50 in your pocket, which makes this type of passive income available for the public at large.
If you are looking for ownership in real estate instead of being a debt buyer and holding shares as the asset instead of loans, it usually requires a bit higher minimum investment in real estate equity crowdfunding. For example, to invest in rental apartments in Copenhagen at Brickshare requires a minimum investment of 5,000 DKK (roughly 675 euro) and to invest in German rental apartments at Exporo requires a minimum investment of 1,000 euro. However, for real estate equity development projects with more short terms, it is possible to get in at £100 on Brickowner.
The main difference between Real Estate Equity Crowdfunding and Real Estate Investment Trust (REIT), where it is also possible to gain exposure to equity ownership in real estate, is the pooling of investments. In a REIT you buy into a pool of real estate assets, whereas real estate equity crowdfunding enables you to buy into specific projects or smaller companies that can own down to as little as one rental apartment.
Passive Income With Dividend Stocks
Another great resource for generating passive income is dividend stocks. Dividends are company profits that are distributed to shareholders who own stocks in the company. Some companies pay dividends on a regular basis, meaning shareholders will receive earnings when they own stocks directly in the company or through index funds as a form of dependable income.
Of course, the amount of passive dividends you receive depends on the number of stocks you own as this determines how big of a portion of the company’s profit that will be distributed to you. This means that you need to buy a rather significant number of shares in dividend-paying companies to see a healthy passive income stream from your dividend stocks – especially because dividends are usually taxed right away. Tax on dividends usually range between 1.5% and 3.5% of the purchase price, while substantial capital gains or losses can occur too.
As it goes for most passive income investments opportunities – and investing activities in general – investing in dividend stocks, as well as other types of stocks, comes with a risk, since they can drop in value and you might end up losing money.
One way of mitigating your company-specific risk is to buy shares in multiple companies. In that way, when one company drops in value on the stock market, another company might rise in value. This is done to balance the risk and to, hopefully, increase the long-term gain. Following a diversification strategy, you will spread your risk and are less likely to be seriously affected if one of your shares should fall in value. Though diversification can help to mitigate the company-specific risk, the overall market can still rise and fall in value – leaving you vulnerable to the so-called market risk.
Passive Income by Lending to Big Businesses or Governments
One of the safest ways of ensuring recurring passive income is by lending money to governments or some of the worlds biggest companies. It is the traditional way of securing your money and to generate a predictable stream of future cash inflow. This can be done through investing directly in bonds or an Exchange Traded Fund (ETF) for bonds. With the development of more modern finance techniques, it has even been possible to lend directly to a municipal in Denmark through a crowdlending platform.
When it comes to investing, most people know and talk about stocks and about having ownership in businesses. The same is true for the media in general. However, bonds can be a great way to create stable cash flow. Usually, people have bonds to complement stocks and balance their portfolio, so that when the stock market fall, the bonds do not (or at least not as much).
In almost every bank, if you ask your banker about how to invest, they will follow the Dedicated Portfolio Theory by Martin L. Leibowitz and/or the Modern Portfolio Theory by Harry Markowitz to advice you about how your investment portfolio should be set up. They will probably also use the rule of thump saying that having 60% stocks and 40% bonds is the optimal risk/reward ratio and then they will usually advise you to have a larger and larger percentage of bonds the closer you get to retirement.
The Dedicated Portfolio Theory is used to give a good estimation of how much you would need to invest at a certain allocation for obtaining a specific cash flow. So with Martin L. Leibowitz’s theory, it should be possible to say, for example, that you desire a cash flow of 100.000 in the next 10 years and then put together a portfolio of fixed income with the needed interest and maturity of the bonds. Put simply, the 10-year bonds can be thought of as an “income portfolio” dedicated to providing a predictable stream of income for the next 10 years, while the rest of the portfolio can be thought of as a “growth portfolio” dedicated to providing the growth needed to replenish the income portfolio.
This way of thinking can also be utilized when considering other investments than bonds by taking the intended cash flow as the main goal and looking for investments that – with consideration of risk – provides the desired cash flow outcome. The reason bonds are valuable in this theoretical perspective is that you know the coupon rate of the bond and the date to maturity and at the same time governments and big businesses are estimated as being lower-risk assets. In comparison, stock dividends and loans to smaller businesses or consumers are more unpredictable in terms of changeable income and default rates – and after all, bonds are the only way to buy investment papers that let you profit on the performance of a government; how often have you heard someone talking about a stock that enables you to get ownership in the German government?
Passive Income With Peer-to-Peer Lending
The last passive income strategy this article will take you through is P2P lending, which is also often referred to as crowdlending, lending-based crowdfunding, or social lending. P2P is an abbreviation of peer to peer, which is actually what P2P or peer-to-peer lending is about: peers lend money to other peers without the intermediation of a bank or a traditional financial institution.
Put differently, P2P lending is the practice of lending money to individuals or businesses via online platforms that aim at connecting lenders, who possess a certain amount of capital, with borrowers, who need financing to carry out a specific project.
The reason why P2P investing has grown popular is simple: if done well, it is profitable. Just look at the banks; why do you think they lend money out to individuals? They do it because it is possible to generate a substantial profit from lending activities.
Peer 2 peer lending is really a quid pro quo for everyone involved for several reasons. In some cases, borrowers, who don’t usually qualify for traditional loans from banks, have the possibility of getting a P2P loan, and lenders can earn attractive interest rates that are high above the average compared to other more conventional investment options. However, it is also a common misconception that not qualifying for a bank loan or not having other alternatives is the most common reason for borrowing through P2P lending. Depending on the type of peer-to-peer lending, other common reasons for borrowing money using P2P lending are:
- Time – It is usually possible to get financing faster than through a bank.
- Costs – Some borrowers can save money by lending through P2P.
- Marketing – Depending on the business type of the borrower, peer-to-peer lending can turn financing into a marketing channel for the company by, for example, offering a 5% discount on everything at a webshop or in a store to lenders.
- Transparency – P2P lending is usually a very transparent type of financing and often have similar terms for all companies borrowing at a platform, compared to individual contracts in a bank that can be hard to understand.
As an investor in peer-to-peer lending, it is extremely important to note that the interest rates usually follow the risks (risk/return ratio). Thus, finding loans of 10% or more, taking the default rate into account and that we have a low-interest environment in the general economy, is not very common on the safer real estate or business loans.
On P2PMarketData, you will find a thorough and informative overview of some of the world’s biggest P2P finance marketplaces and platforms offering peer-to-peer loans and equity crowdfunding.