In the last article, we looked at what passive income is and how it differs from active income. You should read that article in full, if you haven’t already, but let's recap things briefly.
Active income is where you get paid for the work you do. You’re paid an hourly rate or a fixed fee for a given piece of work. When the work’s done, you get paid. End of story.
Passive income is different. Rather than getting paid for a specific piece of work, you create something of value; it can be a product like an eBook or a service like web hosting. Once the work is done, it’s pretty much complete as far as production goes, but it can keep making income long term:
- Your eBook sits there on Amazon quietly selling away, bringing you in a couple of dollars every day.
- Unless something goes wrong with your web hosting set up, your clients send you money every month and their websites stay online.
While the initial work—writing the eBook or setting up the servers—was unpaid, there’s no limit to how much you can get paid going forward.
Today, we’re not going to focus so much on passive income. Instead, we’re going to dig deeper into active income, explore why it’s just trading time for money, and look at ways to move away from it towards passive income.
Trading Time for Money
Active income comes in many forms but at their core they’re all the same: you trade your time for someone else’s money. Let’s look at a few hypothetical examples.
1. The Hourly Rate
Bryan is a high school kid. He wants a bit of extra cash to buy a Nintendo Switch, go to the cinema (yes, really), and a few other things. At the weekend, he works in a local grocery store where he’s paid $10 an hour to stack shelves. If he works ten hours over the weekend, he walks away with $100. If he only works two hours, he gets a paltry $20.
Bryan’s situation is the most obvious example of trading time for money. He is literally selling an hour of his day for $10. If he sells more time, he gets paid more. If he doesn’t work, he gets absolutely nothing.
Bryan is obviously trading his time for money.
Most situations, however, aren’t quite this clear cut. A lot of jobs don’t pay an hourly wage but a monthly one.
2. The Salary
Jess works in a graphic design firm. She’s good at her job and has been there a few years so she gets $60,000 a year (we’re going to ignore taxes for the sake of easy maths). She’s meant to work 40 hours a week, but she seldom does. If there’s a deadline coming up, she might spend as much as 100 hours a week in the office. Who cares if it’s a Saturday when a project is due?
Jess’s situation is all too common. If she actually works 40 hours a week, she is selling her time at a little over $30 an hour (here’s how to calculate the value of your time). That’s not a bad rate and she still gets plenty of free time to spend doing whatever she wants.
The problem is that Jess isn’t paid $30 an hour; she’s paid $5,000 a month. This means that when projects run long and she’s in the office until midnight, she doesn’t get paid any extra money. When she works 100 hours a week, she’s being paid the equivalent of $12.50 an hour.
While this situation isn’t quite as clear cut as Bryan’s, it works out much the same. Jess is selling her time for a variable amount of money; even worse, she’s losing control over her own time. Her boss doesn’t care that she’s meant to have dinner with her wife, a deadline is coming up.
It’s worth noting that some people will actually have the opposite problem to Jess: they’re required to be in an office from 9am to 5pm but the work they’re responsible for takes them a fraction of this time. Instead of being able to leave at 1pm with everything done, they have to sit around, posting on Twitter until everyone else is done so they can leave. Simply put, salaries can be quite a trap.
3. The Freelancer
Even freelancers aren’t safe from trading time for money. Harry is a freelance writer (this example’s not so hypothetical). Amongst other places, he writes for one of the top tutorial websites in the world, Envato Tuts+. Tuts+ doesn’t really care what Harry does with his time as long as he submits his articles and they don’t need too much editing. If he writes them in bed wearing nothing but a pair of tighty whities, it doesn’t make a difference to his editor.
Harry gets paid a set rate per article. For the sake of easy maths, let’s say it’s $100 (it isn’t). Every article he writes, regardless of how long it takes pays the same. If he bangs it out in an hour, he’s earning a whopping $100 an hour; if he spends three days and twenty hours grinding it out, he’s on a poverty inducing $5 an hour.
Now, Harry isn’t directly trading time for money. He’s trading a product—in this case an article—for money. But, because each article can only be sold once and takes a certain amount of time to create, it works out the same. How much time he trades for each crisp $100 PayPal deposit, is entirely up to him. He’s got a lot more freedom than the likes of Jess or Bryan, but if he stops writing, he stops earning.
The Problems With Trading Time for Money
As should be pretty clear by now, there are some pretty big problems with trading time for money.
First, you’re relying on someone else’s good graces for your financial security. If Bryan’s boss doesn’t need him this weekend, Jess gets fired, or Harry’s article doesn’t get published, they won’t get paid. For this reason, they all need to keep their bosses on their side. Bryan probably doesn’t have to do too much, but Jess is required to stay long hours in the office when a project is due, and Harry occasionally has to write articles that bore him to tears.
Which leads nicely into the second issue, by selling your time for money, you lose a lot of flexibility in how you spend it. If Jess wants to go to Burning Man with her wife, she’d better hope that there are no projects due around then; if there are, she knows there’s no way her boss is going to let her have the time off. Harry might want to go to a party tonight, but if he’s got a looming deadline, he needs to have his work done first, otherwise his editors won’t be happy. How much limits are placed on your time, depends on your exact situation but there will always be some if you’re trading time for money.
Third, you’re only able to sell each hour in the day once. Bryan gets $10 an hour stacking shelves, but he can’t do anything else with that hour or sell it on to anyone else. You’re trapped in a constant cycle: you need money to live, so you sell some time to get it, but then that time is gone. If, instead, you have a product like an eBook, you can sell it again and again and still get paid as much the hundredth time as the first.
Passive Income Still Takes Time
It’s a myth that passive income takes no time; the equation is just different. The key is that rather than selling individual units of time, you’re investing them in the hope of a greater return.
Let’s continue the eBook example. To write a good book, it takes, say, 1000 hours. That’s about six months full time work. That work is split between writing, editing, layout, design and so on. You don’t get paid a penny for those hours at that time.
Once your book’s published, it does really well (we can hope). Over the next two years, you earn a total of $100,000 from sales through Amazon and other retail channels. Cha-ching. You’ve hit the holy grail, reliable passive income.
But let’s step back. That $100,000 took 1000 hours of work to earn (we’ll ignore marketing, customer support and so on for now). That means you got a return of $100 for each hour you invested. That’s not bad, and over the next few years, that number is only going to continue to grow.
This situation, however, is only what happens if your book does well. If it tanks and you get $1000 worth of sales over two years, your return was $1 an hour.
This, then, is the crux of it. When you’re working on passive income projects, you’re investing your time, rather than selling it, with no guaranteed return. If things go well, your return could essentially be infinite; if things go badly, you would have been better off financially stacking shelves for $10 an hour.
Sell, Invest, or Use
To get started with passive income, you need to change your mindset. Start thinking about the hours in your day as something you’re either selling, investing, or using.
To keep afloat until your passive income business takes off, you will almost certainly need to keep selling some hours. That’s just part of life. You’ll also want to use some hours for things like eating, sleeping, exercising, watching Netflix and hanging out with friends; these are all very important things and a great way to use your time. Time you use doing something you love is not wasted.
What it all comes down to then, is what you do with the hours you decide to invest. Over the next few articles, we’ll be looking at ways to use them wisely. Learn more about the time value of money:
A Note on Leverage
One thing it’s worth noting is that there are ways to leverage your investment of time. If you have money, you can always buy other people’s time. Say, for example, you’re setting up a website. You can hire freelancers that will do the job for you.
The other great tool for leverage is automation. If you invest some time in creating systems that don’t need your direct attention, it will often pay off. Take the web hosting business: one way to run it is so that each new customer has to call you and be taken through a setup process, another is to create an automatic system that on-boards new customers. In the first case, you’ll still have a lot of hands on time, in the second, you can sun yourself on a beach while a computer does all the work.
Trading your time for someone else’s money is how almost all jobs work, whether you’re a high school kid, career professional or freelancer. You take an hour of your time and get $X back. The problem with this situation is that you lose control of your own time. Especially if you’re in a salaried job, you might end up working far more than you are meant to.
Passive income still involves some trade of time for money but it’s an investment. You put in X hours now with the hope of getting a return of $Y in the future. In the next few tutorials, we’re going to look at how to go about doing just that.
Editorial Note: This content was originally published in 2017. We're sharing it again because our editors have determined that this information is still accurate and relevant.