Passive income is about getting your money to earns its keep.
There’s no way in hell that I can get to FIRE by blood, sweat and tears alone. If that were true, generations of miners back in the day would have retired to lives of quiet luxury after a few short years in the pit. We all know how well that turned out.
Usually, when someone mentions “passive income”, a chubby white guy on YouTube interrupts your funny videos and tries to sell you something. Not this time!
...but if you’d like to buy my free eBook on Amazon FBA…
Just kidding – I have never tried Amazon FBA and I’m not selling a book/ DVD/ “free workshop”.
The concept of passive income
Before the internet became a thing that all desk jobs plugged me into all day, I hadn’t heard of “passive income”.
Ironically, having been born in the late 1980s, I’d actually lived through the heyday of ridiculous returns and passive income. I remember earning 4.5% interest on cash savings back in 2006. All those opportunities that passed me by and not once did a chubby white guy appear on my Nokia 3310.
The idea with “passive” income is that you put your money into it – or, your time up front – then it plugs away in the background making money while you sleep. This is because money doesn’t have to sleep. Conceptually, if you have enough money doing this for you, you don’t have to work at all.
It’s basically what makes FIRE possible.
Unfortunately, not all passive income is that passive, and some is more painless than others to generate. Let’s have a look at the common ones anyone can start to earn.
Interest on savings
Ah, the classic passive income, beloved of GCSE maths teachers.
The idea is that you dump a load of money in a bank or building society and they use it as collateral to borrow money from other banks on the inter-bank money markets. The bank then lends this out – mortgages, loans, credit cards and so on – and rewards you with a cut.
This is pretty safe in the UK. The Financial Services Compensation Scheme means that the government will pay you back up to £85,000 per person per bank if your bank goes bust. Obviously, if you’re in the great place to have more than £85,000, there’s nothing to stop you spreading your pot around a few banks to maximise this protection.
Cash savings can be held in an ISA, a tax-exempt savings account, or just a regular savings account. The first £1,000 (in 2020/21) of savings interest earned outside an ISA is covered under a tax allowance.
Good things about savings interest
- You don’t have to do anything to earn it, really.
- Your money is always there, which is important if you’re going to need it in the next 1-5 years.
Why savings interest sucks in 2021
- Interest rates are less than 1% on pretty much every account. If inflation is aiming for 2% each year, you’re assuming that best case is that you lose wealth at a rate of 1% a year.
- There is little to no chance that the banks are going to raise interest rates soon, because low interest rates usually encourage spending and we’re broke due to COVID.
Interest on gilts and government bonds
Remember bonds? They pay a coupon. That’s basically an interest rate.
Gilts and western government bonds (hold fast, Italy and Greece in recent years) are pretty safe. A government can restructure debts and dishonour them, but it’s usually bad times for the country if it has to resort to that kind of thing.
Again, you don’t have to do much. However, finding the bond you want at the price you want to pay is less certain. Bond ETFs are quite expensive at the moment and yields are low. You might potentially buy them overpriced and sell them after the price has stabilised, which will eat into your passive income. Best bought for the long haul.
Bond funds can be bought in a stocks & shares ISA, a general investment account, or a SIPP.
BONDS are good if
- You want to earn more cash than savings interest is going to get you.
- The stock market is way too volatile for you to rest easy at night.
- You are going to put your money to work for a long time.
- You’re already FIRE/ a pensioner and you need the money to be there more than you need it to grow.
Bonds absolutely suck if
- You reckon you’ll need that money back soon.
- You’re expecting decent growth. Yields are at historical lows, it just isn’t going to happen.
Dividends
A lot of shares pay dividends. This is great passive income, as again you bought some shares or an equities ETF and now the company is giving you the slice of tasty tasty profits you’re entitled to.
It’s a bit like making a company work for you.
Good examples of dividend paying shares are McDonald’s and Coca-cola. Usually, dividend yields start low, as they’re shown on a share price chart relative to the share price. However, as share prices of successful companies tend to increase (with inflation, if nothing else!) then the dividend payments will probably increase, too.
The thing with this is that you own equities (shares), whose prices fluctuate. There’s also no guarantee that a dividend will be paid, it’s in the hands of the board of directors.
(There’s an exception, which is Real Estate Investment Trusts… but that’s another story).
Dividends can also be paid by a company that you own, like a side hustle business if it’s set up as a limited company. This is cool because dividends aren’t subject to national insurance and are taxed less than wages.
There is a £2,000 a year dividend allowance in 2021, which means that dividends held outside of an ISA or SIPP don’t get taxed for the first £2,000 of them. Nice.
Why dividends are awesome
- It’s basically making a big company work to make you richer.
- You don’t have to do anything after buying the shares – just hold them.
- You can earn them in an ISA or a SIPP… as well as just a general investment account.
- They’re taxed lower than other sorts of income.
Why dividends alone can’t solve your problems
- They’re not guaranteed in amount or frequency of issue.
- The business paying them might collapse like a flan in a cupboard.
- Yields tend to start low, so you need to build those bad boys up.
Things that aren’t passive income, but are like passive income
Passive income, by definition is income – it comes in with a degree of predictability.
That said, some things grow by capital appreciation. That has nothing to do with liking the sites of Paris or Berlin. It means that they just go up in value over time.
There are many reasons why something will increase in value over time. Scarcity is a good one: if there is demand for an item that’s not made any more, or better yet if the item is becoming rarer, it tends to go up in value. Pretty simple supply and demand.
You know what? Let this charming Aussie guy from the YouTube channel Economics Explained tell you about how this worked with Pokemon cards last year.
Technically, anything could have a capital appreciation, but most stuff doesn’t. In fact, most stuff depreciates – it actually makes you poorer over time.
Here are some common things that have capital appreciation.
Houses and Real Estate
Brits love us a good ol’ house fetish. Most people think houses make money compared to renting (that’s actually rebuttable…) because historically they’ve increased in value.
I’m not an estate agent, I don’t value houses, but the long and the short of it is that not enough houses get built so their value increases in in-demand areas over time.
This goes back to your classic supply and demand balance.
This isn’t income, since you can only realise the gain by selling the house, which you probably live in. It can be income if you rent the house out (hooray!) but generally it’s just a bit of capital appreciation.
Share price growth
When you have a stocks and shares portfolio, it (hopefully) goes up in value over time.
Some of this will be from dividends, but a lot of it will be changes in the value of the shares themselves. It looks a lot like passive income, but it’s technically capital growth.
(I wouldn’t lose too much sleep over it though, as you tend to have a whole lot of shares and are usually pretty happy to sell a few to realise the gain.)
Collectibles and antiques
The darlings of daytime TV and badly-maintained shops in twee market squares.
I literally don’t know anything about antiques or collectibles. There was a guy I met once who bought, refurbished and then sold antique lamps, but that requires serious knowledge to get right.
That said, it’s technically true that some antiques and collectibles grow in value over time. This is capital appreciation, but it’s basically passive growth because a lot of these things don’t need much maintenance.
Why passive income is the key to FIRE
Clearly, there’s only so much money you can earn in a day. You might end up earning a few hundred thousand pounds a year after tax, if you’re very very lucky and make the right moves. That would help, sure, but it’s still a simple exchange of your time for money.
Time is worth more than money. It must be, logically, as you can find money anywhere but you can’t (yet) extend your life: that clock is always ticking.
If you can generate income in the background passively, you can start disconnecting your time from making money. You can keep more of your time, because your money is making more money for you.
I stole this idea from Rich Dad Poor Dad, which may or may not have stolen this idea from a Vicki Robin book Your Money Or Your Life. As I haven’t read Vicki’s book, I haven’t linked to it (I’m not going to shill any old thing!) but you can see Rich Dad Poor Dad in my recommended section.
The top 5 sources of passive income in 2021…
Just kidding. I hate those posts. However, I will start posting about some of my side hustle attempts, to show just how “passive” some of the “top passive income ideas” out there are.
