People at every stage of life dream of building wealth to sustain their lifestyle and give them freedom. Generating passive income is a smart way to do this. The best passive income approach for you will depend on how much risk you’re willing to take, how much work you want to do, and what your financial goals are.
Passive income is essentially income that you earn without being actively involved in generating it. Comparatively, active income is the income you make from what you would consider your day job.
Whether you do it to make a little extra money or have grander goals of early retirement, taking steps toward building easy passive income is a wise move. If you’re using passive income to build a nest egg, it can also act as a safety net if your financial situation changes. When done successfully, making passive income may give you the financial freedom to work as much or as little as you like, travel, do charitable work, or focus your efforts on what is important to you.
There are multiple strategies you can use to build passive income. Explore these four ideas to see what approach might be the best fit for you.
Build on your passion and expertise by creating something that will generate ongoing future sales. Though not completely passive because it requires some effort, you can monetize your passion projects through side projects, such as:
If you invest in a business but have no involvement in running it, you can generate passive income from the profits. Of course, there is some risk involved when your investment relies on the success of a leadership team that doesn’t include you.
Investing in real estate that you—or ideally somebody else—can manage is a classic way to generate passive rental income. This might include:
Investing in mortgage funds is one of the best passive income approaches because, unlike managing rental properties, it truly requires no involvement on your part. You simply invest in a fund that lends to real estate investors and make money on the interest.
As with all types of investing, passive income strategies come with tradeoffs. Consider the degree of control, time investment, risk, and your desired monthly income. Control means how much of the investment is under your control versus what you leave to others. Time investment means how much of your time you must dedicate toward the investment. Risk speaks to the degree of risk you are willing to accept. And if you have a monthly income target, it may preclude certain types of investments.
Think about how much time and money you’re willing to invest to generate passive income. For example, marketing a product requires a large amount of up-front work, sales tax maintenance, ongoing marketing costs, and significant human capital. Managing a rental property often requires an up-front investment for upgrades and repairs, tenant interactions, building upkeep, and ongoing maintenance costs. Short-term rentals come with wear and tear on the property and ongoing costs and efforts of cleaning and turnover.
With mortgage fund investing, the fund does the work to vet borrowers, and the borrowers do all the work. You make money on the interest with steady monthly or quarterly payments that require no effort on your part. However, the tradeoff is likely a lower rate of return.
Do you need your passive income to be predictable? Do you depend on having a minimum income from this source? What happens if your rental property sits vacant for a few months? If you invest in rental properties, having cash reserves is essential for handling the unexpected.
What if you invest in a company that goes bust? When investing in a business, not participating in day-to-day management means you have little or no influence on its success. Your income depends on the business being profitable, so think about how that aligns with your risk profile.
Think about how liquid you would like your investments to be. Can you take funds out if you need to, or are they locked up for a certain amount of time?
Earned income from passive sources is taxable—in some cases, even if you don’t take the income and reinvest. Consider this when deciding which path is right for you. Is the effort worth the amount you get to keep? Depending on the type of investments you make, earnings could be taxed as passive income or portfolio income. Work with a professional to determine the best passive income tax strategies for your situation.
When you invest in mortgage funds, you get consistent monthly or quarterly distributions based on the interest payments generated from loans. Due diligence is critical, so do your homework on the sponsor, their track record, and the risk you’re taking. Look for a sponsor that has seasoned underwriters and a risk profile that aligns with yours, a long track record, reputable references, and consistent performance.
Check with the sponsor about the lockup and liquidity rules. How long is the lockup: 6 months, 1 year, 3 years, 5 years? Can you redeem quarterly or annually? Is there a limit or gate to when and how much you can draw down? It’s important to understand the investor requirements before jumping in with both feet.
Socotra Capital has been serving investors since 2007 with a strong collection rate and competitive investor yields. For more tips and ideas on the best passive income strategies, read How to Grow a Passive Income Portfolio in Today’s Market.