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What is Passive Income and How Does it Actually Work?

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Read Time: 10 min
This post is part of a series called How to Create Passive Income (Complete Beginner’s Guide).
Passive Income: How to Stop Trading Your Time For Money

Since the release of The Four Hour Workweek by Tim Ferriss, “passive income” has been held up as this mystical thing that, if you manage to get it, you’ll be free to live the life you want. 

Will passive income really give you the dream lifestyle?Will passive income really give you the dream lifestyle?Will passive income really give you the dream lifestyle?
Will passive income really give you the dream lifestyle? Read on to get the full scoop. Image source: Envato Elements

A quick Google search will turn up websites (some good, some decidedly scammy) that claim to teach you how to use passive income to “earn money while you sleep”.

If you’re just starting out or have a small business, you might be tempted to try and get some of this Holy Grail action. Before you do, let’s step back and look at what passive income really is, what’s involved in getting it, and how it works.

Active vs Passive Income

There are two kinds of income: active and passive. 

1. What Is Active Income?

Active income is where you get paid for work you do. I’m getting paid for sitting down and writing this article. I’ll get paid once and that’s the end of it. 

If you’re in a regular job earning a salary, or do freelance work for clients, then you’re earning active income. It’s what keeps the world ticking over. Whether you’re a barista or barrister, you’re trading time, experience and effort for cash right now. The amount your paid changes, but the principle remains the same. 

2. What Is Passive Income?

Let's now define passive income because it's different. Rather than being paid once for the work you’re doing, you create something (or create value) so that you continue to get paid indefinitely. 

The simplest example of passive income is someone like the author Stephen King; he spent a few months writing The Shining almost 40 years ago but he’s still being paid for every copy that gets sold. He created something of value that people still want today.

There Are Many Ways to Earn Passive Income 

The internet has opened up many more opportunities for people who aren’t famous authors to earn passive income. 

If I wrote this article on my own website instead of Envato Tuts+, then all the ad revenue would go to me. Rather than get paid a couple of hundred bucks now, I’d get a few cent for every person who clicked on an ad.

There are hundreds of ways to earn money with passive income. 

You can sell your own products, use affiliate schemes, collect ad revenue and much more. Even traditional investing is a kind of passive income. 

Let’s have a look at some hypothetical examples of passive income earners based on people I know. These should give you some idea of the range of possibilities. 

1. The WordPress Theme Developer

Envato is actually responsible for helping thousands of people earn passive income, one of them is our hypothetical WordPress theme developer, Brian. 

Brian spends a few months developing an awesome new WordPress theme that’s easy to use for regular people. Once he’s done, he releases it to the public through Envato Market’s ThemeForest, which is an online marketplace shown here:

ThemeForest helps thousands of people make passive income.

When a customer is looking for a new WordPress theme, they plug something like “awesome WordPress themes” into Google and stumble across Brian’s theme on ThemeForest. The customer clicks Add to Cart and Envato does the rest. Brian wakes up one morning to find an extra bit of cash in his account. 

2. The Travel Blogger

Our travel blogger, Sarah, loves nothing more than seeing the world and sharing her experiences with her readers. Whenever she goes to a new place, she writes about all the cool things she does there. She’s making money in a few different ways.

All the ads on the sidebar of Sally’s site are for cool things she thinks her readers will be into. If any of them click through, Sally will get a small fee. She also recommends services like Airbnb to her reader. She’s signed up to the affiliate program, so she gets a discount code to give to them. If any of them use it, Sally will get a cut. 

Finally, Sally knows a couple of cities really well. She’s found all the best restaurants, things to do and places to stay. She’s put together a few short guidebooks that are available from her site for $5. Any time one of them sells, she gets to keep the full amount.

3. The Manufacturers

Just like Sarah, Tom and Betty love to travel. One thing they’ve found though, is that no bag suits their needs perfectly. Rather than moan about it, they decide to make their own.

They put their finished bag up on Kickstarter and made enough to get it off the ground and start selling it online. They use a fulfilment house so they don’t have to do any of the shipping or handling themselves. The bags get sent straight from the manufacturer to the customer without them even seeing it. 

Their dream bag took them years to develop, but now it’s sitting their earning them money while they travel. 

The Dream of Passive Income

It’s easy to see why people like the idea of passive income. It sounds great on paper. 

You’re, at least in theory, able to do the work once and get paid forever. Stephen King’s family is still going to be earning money from The Shining when he dies. This is an incredibly tempting proposition. 

Passive income has a few other things going for it too. All the work is front loaded. Once the book is written, it’s written. You don’t have to open up a word processor every day for the rest of your life and change a few words to keep it fresh, you did everything at the start.

passive incomepassive incomepassive income
If you're earning passive income, it doesn't matter what you do with your time... in theory.

Since you’re not being paid for the work you do but rather what comes out of the work you do, with passive income projects, you’re normally free to work from wherever you want. 

Stephen King writes in his attic. You can write on a beach. There are people all over the world making money from Envato Market. You don’t have to go into an office between 9am and 5pm just because someone said you do.

Even better, once the work is done, you’re able to earn money wherever you are. If you decide to take a scuba diving trip to Bali or enter the Mongol Rally, money will keep trickling into your bank account. Even when you’re having a nap, you’re still earning money. 

That's not the entire story of passive income though.

The Other Side of Passive Income

The good side of passive income isn’t a lie; it’s just half the truth. Yes, you can get paid forever for work you did on a beach in Mexico, but there’s more to the story than that.

There’s a reason I’m writing this article for Envato Tuts+ rather than my own site: the amount of money the ads would bring in is tiny. It would take me years to earn the same money Envato are paying me to write it for them now. 

This is true of a lot of sources of passive income. Although you can earn money indefinitely, it tends to be very small amounts. Although you pay ten bucks, Stephen King is earning less than a dollar for each copy of The Shining sold today. 

This leads into the next big issue: a significant portion of passive income projects flop. Writing a book or designing a WordPress theme takes a lot of time and effort to do right, and even if you do it perfectly, there’s no guarantee it will sell. 

For every Stephen King, there are thousands of aspiring authors who spend months writing a novel and never make a penny. Tens of thousands of people have started a travel blog, but only a small fraction of them ever make enough to live on.

Passive income also requires a huge amount of active work. Even after you’ve done all the front loaded stuff, you still need to promote whatever you did, deal with customer support and work on your next project. 

After writing a novel, Stephen King has to do a book tour, press interviews and so on. The sellers in the Envato Market have to make sure their plugins and themes are up to date with the latest versions of the software they rely on, that any customer emails get responded to quickly and that people are able to find their work. 

Travel bloggers have to keep producing new content to keep their websites relevant, update guides, make partnerships with advertisers and so on. If you want to make money with passive income, you can’t just lie back and drink Mojitos; you have to put in a lot more work.

The Truth About Passive Income

Passive income is complicated and anyone who tells you otherwise is a charlatan. Yes, there are all these wonderful upsides, but there’s also a lot more that goes on behind the scenes. It’s easy to look at the Envato Market and imagine all the dollars rolling into your account, but that glosses over the level of work involved. 

On the other side of things, it is definitely possible to earn money with passive income; it just takes a lot of time and effort. Often, from a financial point of view, that time and effort would be better spent working actively; but not always. Dismissing passive income just because it’s not completely hands off, is as silly as diving in head first because you hear you can earn money while you sleep.

One thing that a lot of people miss is that there isn’t a binary choice between active and passive income; you can do both, and they can compliment each other:  

  • If you design websites for clients (active income), you can also get set up with a reseller hosting account and offer to host their sites for a monthly fee (passive income). 
  • If you’re a wedding photographer (active income), you can sell your favourite presets on the Envato Market (passive income). 
  • I’ve had people approach me about paid freelance gigs (active income) after they read something I wrote on my site (passive income). 

How to Get Started With Passive Income

If you’ve got a small business or are thinking of starting one, passive income is definitely something that’s worth exploring. 

You might find it doesn’t work for what you do, but you also might find that there is a relatively simple way to bring in an extra few hundred dollars a month with a passive income side project. You might even find a way to make passive income your main source of income.

To start earning passive income, you need a business idea. Our guides on how to start a small business on a budget will walk you through the process of developing one: 

Next, you need to identify how you can turn that idea into passive income. Are you going to use ads and affiliate programs? Create something to sell on the Envato Market? Make an actual product? The details of how to do that is what I’ll be covering in more depth over the next series of tutorials.

Wrapping Up

Passive income is real, it’s just not exactly passive; it still takes a lot of (initially unpaid) work to get off the ground. Recurring revenue is probably a more accurate phrase to define passive income. 

There are lots of benefits to passive income but it’s not without trade offs. You can work from anywhere, but it’s hard to generate significant amounts of income. You can take as much time off as you like and you’ll still earn money, but the customer support emails will build up. By now, you should get the picture.

Editorial Note: This content was originally published in 2016. We're sharing it again because our editors have determined that this information is still accurate and relevant.

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