Passive, or residual, income is income that’s not directly tied to work. Rather than getting paid X dollars for an hour of your time, you’re paid a set amount for a product or service.
The classic example is books: Stephen King gets a dollar or so for every book sold. No one paid him a set fee for the time he spent writing his books.
While there are thousands of other authors who make nothing because their books don’t sell, there are also plenty of authors like Mr. King that do make residual income every month on their creative work. Pursuing passive income isn't easy, but it is a viable income source you can grow over time.
In the previous tutorial we looked at how to grow your passive income by diversifying into multiple revenue streams. In this tutorial we’re going to tackle the same problem from a different angle, helping you learn: how to grow your passive income into sustainable wealth so you can be financially independent.
Now lets dig into today's tutorial by first taking a detailed look at financial independence:
What is Financial Independence?
Financial independence is the real end goal for many people. It’s where you receive enough income you don’t have to actively work for—in other words, passive income—that your basic lifestyle is covered.
How much revenue you need to be financially independent depends on your circumstances:
- If you’ve paid off your mortgage and student loans and live frugally, $12,000 a year might be enough.
- If you want to travel the world in business class and buy a yacht, you’re going to need upwards of $500,000 a year.
Most people will fall somewhere in the middle of that scale depending on their own personal tastes and family situation. A single person will almost always find it easier to reach than someone with a young family unless their tastes are ridiculously extravagance.
How Much Residual Income Do You Personally Need?
Working out how much you need a month to be financially independent is relatively simple: just tally up every “essential” expense you have. What qualifies as essential is up to you. If you feel you need to lease a BMW, that’s totally fine; it will just make achieving financial independence a slower process.
Once you’ve got your base monthly number, you should consider any future expenses. If you’re planning to have children, there’s going to be some expenses associated with them. You also need to be aware that the amount of money you need to keep the same standard of life will grow around 5% each year due to inflation. If you can live comfortable on $2,000 dollars a month right now, in June next year you’ll need $2,100. Financial independence is a long term goal so it’s better to be err on the side of caution rather than assume you’ll be able to scrape by.
Learn more about how to define passive income and stop trading your time for money:
- IncomeWhat is Passive Income and How Does it Actually Work?Harry Guinness
- IncomePassive Income: How to Stop Trading Your Time For MoneyHarry Guinness
Remember: Wealth is More Than Just Income
While it’s possible to become financially independent just with passive income projects like courses and eBooks, it’s risky. These sort of income generating products are very vulnerable to shifting moods and trends. The people selling Fidget Spinners right now are making a killing, but how much do you think they’ll be earning this time next year?
To become financially independent you need a sustainable income. The easiest way to do that, is through diversifying your mix of passive incomes and investing in assets. We’ve already covered diversifying your passive income streams so let’s take a deeper look at assets.
What Are Assets?
Assets are things like shares, bonds and property. They’re something that can be owned, controlled and converted into cash. In general, assets will hold or grow their value at least in line with inflation. This isn’t to say all assets will match inflation—house prices in Detroit have fallen thousands of percent—but on the whole, if you’ve got a well diversified portfolio, it will match or beat inflation.
Wealth comes from assets. If you earn $100,000 and blow it all on fast cars and cocaine, you’re worth $0 a year later. If however, you earn $100,000, buy a small apartment and rent it out for $1000 a month, a year later you’ll be worth $112,000: the $100,000 for the house you own, and the additional $12,000 you’ve made in rent. Obviously this is a very simple example that ignores lots of details, but the broad strokes are true.
By investing in assets, it’s possible to grow your wealth independent of your income. It doesn’t matter whether your passive income project brings in $10,000 or $10, it doesn’t affect the value of the assets you already hold.
Assets will also continue to grow on their own. House prices will go up. Stocks will pay dividends that can be reinvested. You might be surprised by how much assets can increase in value in just a few years given the power of compounding returns.
Let’s imagine you invest $1,000 in a stock that is returning 7% a year.
- Year Zero: you have $1,000.
- Year One: you have $1,070 (1000x1.07).
- Year Two: you have $1,144.90 (1070x1.07).
- Year Three: you have $1,225.04 (1144.90x1.07).
- Year Four: you have $1,310.79 (1225.04x1.07).
- Year Five: you have $1,402.55 (1310.79x1.07).
- Year Six: you have $1,500.73 (1402.55x1.07).
- Year Seven: you have $1,605.78 (1500.73x1.07).
- Year Eight: you have $1,718.18 (1605.78x1.07).
- Year Nine: you have $1,838.45 (1718.18x1.07).
- Year Ten: you have $1,967.14 (1838.45x1.07).
In ten years, you’ve almost doubled your initial investment’s value by doing absolutely nothing. That’s passive income!
Now if you just leave the stock sitting there, it won’t help you much. Sure, you’ll have a lot of wealth on paper, but no income. So how do we convert assets back into income so they can cover your monthly expenses?
What is the Safe Withdrawal Rate?
The key part of assets is that they can be converted into cash. You can sell a stock or house and spend the cash on your lifestyle. The whole point of growing an asset portfolio is that, when you eventually stop working entirely, you’ll be able to live on the proceeds. But how much of your portfolio can you turn into cash in a given year and have it last forever?
We’re going to ignore dividends because, even for extremely high value portfolios, their returns tend to be very low. Selling assets is a more reliable way to get a decent amount of money.
The best number that’s thrown around for the safe withdrawal rate (the amount you can safely withdraw from your portfolio and have it last essentially indefinitely) is 4% per year. This means that if your asset portfolio has a value of $1,000,000, you can withdraw $40,000 a year; enough for many people to live on.
Even when you’re withdrawing at 4% a year, your portfolio should still continue to grow at least apace with inflation. This means that you’ll be able to reliably retire on it, assuming it’s well diversified and Western civilisation doesn’t come crashing down. That’s true financial independence.
How to Build Your Asset Portfolio
Building an asset portfolio is a lot more surefire way to reach financial independence than trying to rely exclusively on passive income products (though they can play a role). Unless house values absolutely tank or the stock market collapses, your assets will hold or increase their value for as long you own them.
This means that in two or ten or twenty years when you want to become fully financially independent (and not even have to worry about generating passive income), you’ll be able to convert them into cash. So let’s look at how to build an asset profile.
A simple step is to prioritise passive income projects that are themselves assets. These include obvious things like buying apartments to rent out on AirBnB, but also things like building websites.
There is a large secondary market for successful sites that are generating revenue. You should be able to sell one for between two and five times the annual revenue. If your site pulls in $1,000 a month, it’s worth between about $24,000 and $60,000. While it’s in theory possible to sell the copyright to your eBooks, learning products, Wordpress Themes, or courses, the market isn’t as established and you might struggle to easily turn them into cash in a hurry.
- Income15+ Quick, Easy Ways to Start Generating Passive IncomeHarry Guinness
- Income8 Best Ways to Make Passive Income Online in 2017Harry Guinness
The next step is to invest at least some of your passive income revenue in stocks and bonds. These will continue to grow in the background. You’re essentially just putting your already passively generated income into another type of passive income. If you still earn active income, you could invest some of that too.
The earlier you invest in stocks and bonds, the better. As we covered above, compound interest is powerful. You won’t see much return on your money inside two years, but in fifteen you could have well over doubled it, even accounting for inflation.
If you have a passive income business bringing in $60,000 a year, living cheaply, or keeping a regular job, and investing almost all its profits in assets can quickly get you to the point of financial independence.
Financial independence is a hell of an end goal. If you make it, you won’t even have to do the bare minimum of work that’s required to keep passive income projects going.
You’ll be free to spend your time exactly how you want. This might mean writing a novel you know is likely to be unprofitable, dedicating your time to charity, or just lounging on a beach—with mojito in hand.
Passive income is a great tool for getting there, but it can only really help you on the way. To be truly financially independent you need to build wealth through owning assets. That way, they’ll continue to grow and when you need to, you can convert them into cash to support your lifestyle.
Learn More About Passive Income
In this series of tutorials we take a deep dive into passive income. Learn more about how to get started in these Envato Tuts+ tutorials:
- How to Quickly Start to Make Passive Income.
- 15+ Quick, Easy Ways to Start Generating Passive Income.
- How to Evaluate Your Passive Income Ideas For Opportunities.
Or, if you're already making some passive income, but looking to expand with more residual earning projects, then read through how to develop multiple passive income streams.