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. There are several valuable passive income sources in Australia, 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 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 (EPS), you can enjoy a regular, growing income stream from your dividend-paying shares to supplement your work income. Alternatively, you can reinvest your dividends to buy more shares, thereby compounding your passive income stream for future use – perhaps in retirement, for example, when you won’t be receiving work income. 

A bonus of dividend income is the ability to earn franking credits, reducing 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 many different dividend-paying shares in various industries, which also helps to lower risk through diversification.

Passive income from bonds (fixed interest)

Bonds are a type of debt that companies or governments can use to fund projects. When you buy bonds, you effectively lend money to the bonds' issuer. In return for borrowing your money, the issuer (a company or government) pays you regular fixed interest payments called coupon payments, which is your 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 creditors’ queue to be paid back, ahead of the shareholders.

Investing in bonds can be done through big investment brokers or through an EFT 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. 

ETFs also make it easy to reinvest your 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 in the form of weekly or monthly rental payments from tenants. But is this really passive income? 

Managing an investment property can be like running a small business if you do it yourself. You need to maintain and protect the property, and 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.

Instead, you can always 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. So, this makes your income more passive. However, property management typically costs 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), renting out part of your home might be a more manageable option. 

Renting out spare space, like a spare room, on platforms such as 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 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 and industrial 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 where you 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.

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

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 licensing your original photographs to stock photography websites and earning royalties.

If you're savvy with social media and have built up an online following, you could earn income from YouTube views, 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. You can earn a 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 getting started early, as time is vital 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.

Last updated 28 April 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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