What is passive income

What is Passive Income?

Passive income is a regular flow of money that requires little ongoing time and effort to earn. In Australia, there are several valuable sources of passive income including dividends from shares, interest from fixed income investments and rental income from investment properties.

Passive income is an important goal for many investors because it can give them the freedom to choose how they spend their time while still earning money. 

Imagine waking up to find a crisp deposit of cash sitting in your bank account at regular intervals, leaving you free to read, travel or spend time with your family. That is the power of passive income.

Let's dive in and look at some of the options for creating passive income streams.

What are the different types of passive income investments?

Passive income from dividend shares

Investing directly in high quality dividend shares takes a small amount of initial research and can be highly rewarding over the long term. 

Dividend shares generate passive income by paying out a percentage of the company's profits to investors, usually twice per year. 

By selecting companies with growing earnings per share, and reinvesting the dividends to buy more shares, income can grow and compound powerfully over time. 

An added bonus of dividend income is the ability to earn franking credits, which could reduce the amount of tax an investor has to pay at tax time.

Not sure which dividend shares to buy? No problem! Dividend focused exchange-traded funds (ETFs) can spread even a small investment across a large number of different dividend-paying shares in different industries, which also helps to lower risk.

 

Passive income from bonds (fixed interest)

Bonds are a type of debt that companies or governments can use to fund projects. In return for borrowing your money, the company (or government) makes regular fixed interest payments called coupon payments, which are passive income.

The interest payments on bonds are generally lower than returns on dividend shares, but they also come with less risk due to the predictability of the return. 

Additionally, if a company goes bankrupt, the bondholders stand near the front of the queue to be paid back, ahead of the shareholders.

Investing in bonds can be done through big investment brokers, or through an exchange traded fund that holds a basket of different bonds. 

As with shares, an ETF can be a great way to spread an investment across multiple bonds so you don't have all your eggs in one basket. 

Exchange traded funds also make it easy to reinvest interest payments to grow and compound your passive income over time.

Are investment properties a passive income investment?

Investment properties can provide a great source of cash flow from weekly or monthly rental payments from tenants. But is it really passive income? 

Managing an investment property can be like running a small business, if you do it yourself. Not only do you need to maintain and protect the property, you also need to find and manage the tenants. If your idea of earning passive income is relaxing at the beach uninterrupted, this might not work very well.

One way to make investment property cash flows passive is to hire a professional property manager to look after your investment. This takes the day-to-day hassle out of property investment, as your manager will liaise with your tenants, arrange repairs and collect the rent on your behalf. Property management typically costs between 5%-10% of the rental income.

If you can't afford the hefty cash deposit required to buy an investment property (usually 20% of the purchase price), a more manageable option might be to rent out part of your home. 

Renting out spare space, like a spare room, on platforms like Airbnb or Stayz allows you to generate extra cash from an asset you already own. However, make sure you research and understand the capital gains tax implications before going ahead. 

Another way to generate passive income from property is to buy shares in a Real Estate Investment Trust (REIT) on the share market. Your rental returns are delivered to you in the form of distributions (a different name for dividends that is used in relation to funds), usually paid quarterly. 

The beauty of a REIT is it can give investors access to other forms of property investments that typically wouldn’t be available to the average person, such as commercial real estate. 

In addition to this, a REIT usually offers diversification across many investment properties in a single transaction.

What are some great ways to create passive income?

Peer-to-peer lending is another option. This is where you can lend money to other people directly through an online platform in exchange for interest payments. 

Peer-to-peer lending offers higher returns than bank term deposits because the loans tend to come with more risk. The loans are usually unsecured and there is little protection for the investor/lender if the borrower decides to disappear into the night.

Most of the examples so far have involved using financial assets to generate passive income. But if you're just starting out, or you’re creative and willing to invest some time, there are other great ways to develop passive income streams, too.

For example, you could write and self-publish a book (or e-book) and generate passive income from the ongoing sales. Or you could get paid for your love of photography by licencing your original photographs to stock photography websites and earning royalties.

If you're social media savvy and have built up an online following, you could earn income from views on YouTube or submitting videos on Snapchat or through affiliate sales programs from your blog or website. 

Affiliate sales are a kind of marketing arrangement between you and a company, where you can earn commission if someone buys one of the company’s products or signs up for an account or newsletter by clicking through your website to the company’s website.

Building a portfolio of passive income can be fun and highly rewarding. The key is to get started early, as time is a vital ingredient in successful long term investing.  The earlier you start, the more time you will have to grow your passive income from a trickle to a raging river.

 

The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Learn More About Investing with The Motley Fool

Interested in learning more about investing? Then be sure to browse our "Investing Basics" knowledge hub, which we've created to help more people learn about the wonders of investing. It's just our small way of helping make the world Smarter, Happier and Richer.