What is passive income?

Discover how passive income investments are a great way to secure financial independence.

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What is passive income?

Passive income is a regular flow of money that requires little ongoing time and effort to earn. This is in contrast to the active income you earn from performing a service, like the wages you earn from carrying out your regular day job.

Passive income investments are a great way to secure your financial independence. A passive income source can give you the financial freedom to pursue your passion projects – and might even help you retire early!

Imagine waking up each morning to find extra cash in your savings account at regular intervals, leaving you free to read, travel, or spend time with your family. 

You could even use that money to pay off your credit card or save for a new house. That is the power of passive income. Let’s dive in and look at some common passive income ideas.

What are the different types of passive income investments?

There are several ways to earn a passive income stream, including dividend income from shares, interest from fixed-income investments, and rental income from real estate investments.

Passive income from dividend shares

Investing directly in high-quality dividend stocks only takes a small amount of initial research and can be a great way to earn passive income, particularly over the long term. 

Dividend stocks generate passive income by paying out a percentage of the company’s profits to investors, usually twice yearly. High-quality dividend stocks are great set-and-forget passive income investments because they provide a regular cash flow in the form of dividend income.

If you want to buy dividend stocks as part of a passive income strategy, always look for companies with a high dividend yield. This shows how much a share pays out as dividends each year, as a percentage of its stock price.

Suppose you also select companies growing their earnings per share (EPS). In that case, you can enjoy a growing income stream from your dividend-paying shares that can supplement your existing active income streams, like the money you receive as a salary from your day job. 

Alternatively, you can reinvest your dividends to buy more dividend stocks, thereby compounding your passive income stream for future use – perhaps in retirement, for example, when you won’t receive work income. 

A bonus of dividend income is the ability to earn franking credits, reducing the tax an investor must 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 issuer. In return for borrowing your money, the issuer (a company or government) pays you regular fixed-interest payments called coupon payments, which are your passive income.

This is much like a regular loan, where the lender (usually a bank or other financial institution) receives steady interest income from the borrower, which is determined by the interest rate charged on the loan.

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.

You can invest in bonds through big investment brokers or an exchange-traded fund holding a basket of different bonds. 

As with shares, an ETF can be a great way to spread your 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 through weekly or monthly rental income from tenants. But is this passive income? 

The challenges

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

Instead, you can always hire a professional property manager to look after your investment property. This takes the day-to-day hassle out of running your rental property, as your manager will liaise with your tenants, arrange repairs, and collect the rental income on your behalf.

This means you can finally put your feet up and enjoy the financial freedom of owning your investment property, right? Well, that depends on how much rental income you hope to earn. 

The money trickling into your savings account may be less than you had hoped, considering most property managers typically shave off 5%-10% of your rental income as their management fee.

Buying an investment property can also be very expensive. 

The opportunities

However, an alternative passive income idea is to rent out part of your existing home if you can’t afford the hefty cash deposit required to buy an investment property (usually 20% of the purchase price). This can still give you extra rental income without all the hassle of managing an investment property.

Renting out 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 earn passive income from the real estate market is to buy shares in a real estate investment trust (REIT) on the stock market. Your rental returns are delivered to you as distributions (a different name for dividends relating 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, a REIT usually offers diversification across many investment properties in a single transaction.

What are some other passive income ideas?

Peer-to-peer lending is where you lend money to other people directly through an online platform in exchange for interest income. 

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

Think outside the box

So far, most of the passive income ideas we have discussed have involved using financial assets to generate passive income. But if you’re just starting out with little money or are creative and willing to invest some time, there are other great ways to earn passive income.

Many passive income ideas require some time and effort to set up, but once that’s out of the way, they can provide an ongoing extra income stream.

For example, you could write and self-publish a book (or e-book) and earn 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 marketing programs from your blog or website. 

Affiliate marketing is an 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.

Start early

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

While these passive income ideas may not generate immense wealth overnight, the earlier you start, the more time you will have to grow your passive income from a trickle into a raging river.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

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