Earned vs. Passive Income

Most people make money by trading their time for a salary. You work 40 hours a week, and your employer gives you a paycheck a couple of times each month. It’s a pretty simple deal. You come in and work, and you get paid. Stop coming into work, and you stop getting paid. This is called earned income. The amount you get paid is directly related to the amount that you work. (There are always some exceptions to this rule. For instance, vacation and paid leave allow you to not work and still get paid, but the rule still stands. If you stop going into work, you will stop getting paid.)

Passive income (or its cousin, residual income) is different from earned income in that it doesn’t require you to trade your time directly for money. Passive income is generated by systems that earn money constantly, regardless of whether you are working on that system or not.

When most people first hear about passive income, a lot of these terms don’t really make sense. “What exactly do you mean by a “system”? “How does it earn me money when I’m not working on it?” Let’s take a deeper look at some passive income systems and exactly how they generate income.

Passive Income Systems

A passive income system is simply any business, job, or property (physical, intellectual or otherwise) that continues to produce income for you even when you are not working on it. Here are some examples.

Investments – Probably the most “pure” example of passive income is having a large amount of money invested in the stock market, and living off of the interest generated by your investments. This leaves the principal free to be reinvested, generate more income, and the cycle repeats itself. Unfortunately, this option needs large sums of money to make it work, so unless you are already independently wealthy this is not really an option.

Owning a Business – Owning a business can be a great source of passive income. Hire a manager to take care of the day-to-day operations, and your business will generate income even when you’re not there to run it. You can even start a franchise – such as a fast food restaurant, shipping store or janitorial service – and you won’t have to come up with the basic idea or business plan by yourself.

Rental Properties – Have you ever rented a house or apartment? Did you notice how your rent was due every month, regardless of how often you saw the landlord? That sounds suspiciously like passive income. If you own the property, your tenants pay their rent on a regular basis, whether you are there working on the house or not.

Running a Website – Running/owning a website or blog is another great source of passive income. Once you have a decent amount of traffic coming in, there are several methods of monetizing the site: putting up advertisements, charging for content, selling a product, etc. The point being, readers/users are still coming to the site even when you’re asleep, thereby helping you make money.

The common factor in all of these systems is that your time is not tied together with the amount you get paid. This is unfortunate at the beginning because you’ll be working long hours for very little pay. But after while, if you keep at it, your income will start to increase. At some point your income will be roughly approximate to what you would expect to get paid in a similar salaried position. At that time you can decide whether to invest more of your time into your business to increase your salary even higher, or whether you want to lower your hours to spend time on other projects.

Maintenance

There’s one other thing to mention on this topic and that is the maintenance you’ll need to do on these systems. No matter what sort of system you set up or how well it’s done, you’ll always have to spend some amount of time maintaining the system to keep it going. If you have several million dollars in the stock market, you (or your financial advisor) will have to keep an eye on how your investments are doing to make sure you’re still making money. If you own rental houses and you never maintain them, before too long the roofs are going to be full of holes, the gardens will be full of weeds and you won’t be able to find anyone to rent them from you.

Don’t confuse maintenance with being tied to the clock like a real job. You still get to choose when to work on your business(es), you get to choose whether to do the work yourself or pay someone else to do it, you get to decide what needs to be done about problems that arise, etc. You’re still in charge.

So what other passive income systems are there? I always love hearing about how other people are using some creativity to make money. Let me know in the comments if I’ve missed any.

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This is Part Two in my series on passive income. Check out the other parts below.

1) All Income Is Not Equal
2) Using Passive Income Systems To Make Money

We were pretty proud of cash flow that we had created, but our friend was clearly surprised that the amount was so low. Why be excited about something that makes you only $20 or $30 a month? The answer lies in the difference between earned and passive income. Let’s take a look at that difference, and see why even small amounts of passive income can be so great.

Income

Let’s say I got a job that paid me $1,000 a month. Is that a good or bad job? Most of you probably said it’s a bad job. However, the astute (and amazingly polite) among you said “I need more information before I can answer that question, please, sir.” And you’re right, you do need more information before you can answer.

As it happens, the job I just got pays me $1,000 a month in exchange for 40 hours of work each week. It’s a typical full time job. So is it a good job or a bad job? Well, it’s not too good. Work a full time job for an annual salary of $12,000? No, thanks.

But now let’s say that the job only requires 20 hours per week. The income has stayed the same, but now the job is a bit better. I could get two of these jobs, work 40 hours a week, and double my yearly income to $24,000. Things are looking up a bit, right?

Now let’s say that the job only requires 8 hours of work each week, and your time will be spent testing the comfort levels of various hammocks while on a beach in the Caribbean. Now, that’s a job! You could get 5 of those gigs, spend all your time on the beach, and make $60,000 a year. Not too shabby.

But as good as all of this sounds, there’s still one problem with each of these jobs. They all require you to trade your time for money. Your earnings potential is capped at the amount of time you have available to spend on the job. If you want to take some time off, if you want to scale back your hours to spend more time with your family, or if you leave for a new job, your income is going to decline. Ultimately, if you quit working altogether, your income will stop completely. I’ve yet to hear of a job where they’ll pay you to *not* work.

Talking about income and work in this way probably sounds a bit silly to most people. Of course you have to work to get paid! It’s as basic a fact as saying that the sky is blue or that sticking your finger in a light socket is bad. But the truth of the matter is, this is not the only way to make money. In fact, this is not even the best way to make money. To be perfectly honest, it’s just about the worst way to make money!

Passive Income

Just about anyone who has access to CNBC or the financial section of a newspaper has probably heard about passive income. But let’s take a minute to discuss exactly what it is.

Passive income (and I’m using a practical, working definition of it; not the official accounting definition) is simply income that you earn while you are not working. Or, to be more specific, it’s income from a system or project that is earned even when you are not working directly on that system or project. It is differentiated from earned income, which requires you to be working directly to generate money.

I’m not going to delve too deeply into passive income systems today, but I do want to talk about why passive income is so great. Remember the website up above? Let’s say that it makes $25 each month, with little to no attention from Mary. That means her website is earning her money when she’s watching TV, asleep, feeding the baby or whatever else she wants to do. It also means – and this is the important point – that her website will continue to plug along and make money even when Mary decides to start up a new website. And in a few months, that new website is making $25 a month. And so she starts up another one, and another one, and another one. Before long she’s got a couple hundred coming in each month (or more) and it’s all passive income.

Do you see why we were excited about making $20 from her website now? We’ve since gone on to start several new websites, and her gluten free site is still plugging along for us. That’s the power of creating passive income systems. Instead of being limited by the amount of time you want to spend actively working, you’re only limited by the number of systems you want to create. Right now, my goal is 20 different systems. When I hit that goal, I’ll probably shoot for 50. Why just have one job?

If all of this is too much to digest at once (or if it totally blows your mind), don’t worry. It’s a big paradigm shift, and it can take some time to sink in fully. In some future posts we’ll explore passive income and the systems that produce it more fully, but for now, just give some thought to the strength of passive income and what it could mean to you.

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This is Part One in my series on passive income. Check out the other parts below.

1) All Income Is Not Equal
2) Using Passive Income Systems To Make Money