Your Passive Income Options
Passive Income can come in the form of one any combination of the following:
Dividends, Interest and Loans
I propose to analyse these prospects at a high level, giving arguments for and against each stream. I also intend to give an idea as to what expertise you might need in order to succeed in these areas. These categories can of course be broken down in to specific income streams, for example, property could be broken down into commercial or residential letting, but I am going to stick to a very generally level of detail. As I have used the property example already this is where I will start.
The only way to generate a passive income from property is to purchase a property and then let it out for a set and agreed amount each month. The costs involved in this business include the mortgage, management fees, legal fees, finder's fees, bills and stamp duty. Tax laws vary from county to country. Like any business, in order to produce a positive monthly cash flow, income must outweigh the costs. Mortgage repayments make up most of the monthly costs on an investment property, this amount is dependant on the principal loan amount, the rate of interest on the mortgage and the term of the loan. Lengthening the term of the mortgage loan will reduce the monthly repayments, but increase the total amount repayable. To provide a truly passive income you would need to make use of a property agent, who can charge between 10% and 20% of the rental income in property management fees. The property manager would take care of things such as collecting the rent and ensuring there is always someone on call to provide emergency maintenance to the property. They would also be responsible for trying to minimize vacancy of the property. The biggest risk for any property investor is not being able to service the mortgage debt. This can come about either through vacancy of the property or through changes in interest rate which would increase the monthly repayments on the mortgage. The drawbacks of this investment are that it can tie up substantial amounts of capital in mortgage deposits, and the there is a high level of unpredictability about interest rates, especially over the long term. The upside in property investment can be huge, as an increase in the value of your property can see not only a positive cash flow each month, but a growth in equity on the property. Buying a property at a discount to market value is a great place to start, because it means you have positive equity (i.e. the value of the property is greater than that of the loan) from day one.
Dividends, Interest and Loans
Dividends are paid to equity shareholders either annually or bi-annually. The date on which dividends are paid is called the ex-dividend date. On this date the share price of a stock will fall by the amount of the dividend payment. Dividends offer the opportunity of a passive income, of capital growth through an increase of share value, which is what makes dividend paying shares so attractive. Things to consider when buying dividend shares:
What is the dividend payment as a percentage of the share price? The higher the better!
Has the dividend been steadily increasing? If the stock has a good history of steadily increasing the dividend payments every year, this is a strong sign. Conversely, if the dividend rate has been cut in the last year this should raise questions.
What is the ex-dividend date? Make sure you know this date, as you don't want to sell your share in a panic when the price falls suddenly one day, only to realise that it's the day your dividend is getting paid.
Dividends can provide an excellent alternative to low interest rate savings accounts, but be wary that share value can decrease or increase. Unlike in a bank savings account your money is not insured. There is the option to invest in a fund, who will invest your money for you, but these will charge you for this service, clearly this can eat away at your passive income earnings.
Another alternative to saving is to lend your hard earned money to someone who needs it and charge interest payments to compensate your risk. There are several relatively new online facilities which will allow you to do this. These services aim to allow borrowers to gain a more competitive interest rate, whilst the lenders enjoy higher-then-bank interest rates on their money. If you plan to go down this route ensure the service you are using is regulated and has measures in place to chase people who miss payments and default on their debt. It would be beneficial to have a good working knowledge of loans and interest rates to be prolific in this market. Like other investments these options tie up a large portion of capital for long lengths of time.
A truly passive income requires no (or very little) work effort and time to maintain. Therefore a business is only a passive income stream if you can leave it to its own devices and it will earn you money on its own. Even better if it can grow, and increase profits in this time too! A successful business has the potential to earn your initial investment back very quickly. A business is likely to require a lot of time and effort in the outset, but this should be ramped down as the business matures to a state of reliable income. A common saying is that 'you need money to make money'. Whilst this may be true for some people, entrepreneurs who can successfully leverage other peoples' time, money and experience can start great businesses from scratch. When setting up a business its important to forecast how much the company will be making in the future. One reason for this is that if you can locate your business somewhere tax efficient from the outset, this can reduce your tax costs vastly, and save capital on relocation further down the line. Of course there are a thousand other variables to consider, but I am trying not to be too in depth with my passive income streams breakdown.
There is the possibility of purchasing a franchised business model and brand, if you would like to take on a business is tried and tested. This means that you can use all of the business models that the company already employs, use its suppliers and its brand in order to generate income. Depending on the potential profitability of the franchise you can expect to pay varying amounts to become a franchisee. Arguably the most famous franchise in the world is McDonald's fast food restaurants â you've probably heard of them.
Royalties are essentially payments for use of an asset. This asset can be tangible or could be intellectual property, or a trademark. This means you would be paid for your work every time it is used in the future. Royalties are commonly associated with music, books and other copyrights. For example, authors might expect to receive 20% of the price of the book in royalties every time one is sold (although you could increase your royalty by starting your own publishing company). This is an excellent means of passive income as it is genuinely passive; requiring absolutely no work once the initial asset is created and protected. The main obstacle in generating royalty payments is probably coming up with, and producing something that people will want to purchase for a long time in the future. A good legal knowledge of copyright or intellectual property might be helpful in this field. Unlike other passive income streams, royalties do not tie up any capital in order to be maintained.