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.

********************************************************************************

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

What is an asset?

I started writing this post several days ago and came up with a great definition of an asset. Then I tried to explain my definition to John he completely shot it down – not because it was inaccurate but because it was too complicated. So I’m going to use John’s definition: an asset is something that puts cash into your pocket.

For example, if I own a website that generates $1,000 of advertising revenue a month, that website is an asset. If I own a stock that pays me dividends every quarter, that is an asset.

A business can also be an asset. If the entire business entity has more cash inflows than outflows it is an asset. In fact, a common measure of a business’ value is  its positive cashflow times some industry-specific multiple. If the business is not generating a positive cash flow, it’s not an asset and it’s not worth anything.

What is not an asset?

Things that takes cash out of your pocket are not assets. Most of the things that you buy for yourself are not assets – your car, your house, your dog. While all of these things have the potential to make your life happier, they aren’t assets.

A lot of people think of their house as assets. I recently heard a coworker say that she and her husband wanted to invest in a house while prices and interest rates are low.  What she really meant is that she and her husband were about to pay several thousand dollars to commit themselves to a large monthly payment that they couldn’t afford.

The idea of a personal residence as an investment is one of the greatest fallacies of our times.  The house that you live in has one primary purpose: to shelter you. You can choose to pay for that shelter by paying a monthly rent or by paying one lump sum upfront (purchase price of home).  The home that you buy might appreciate, but that appreciation is completely worthless to you until you sell the house. At which time, you will more than likely use the money to buy another house. The appreciation is stuck in the house – which means that it’s not putting cash in your pocket – which means that your house is not an asset.

Why is this important?

The definition of an asset is important only in that it helps you start thinking about assets. In order to change your financial situation you need to internalize the following two rules:

1. Every stream of cash that flows into your pocket is created by an asset.

Where do you get most of your cash?  Think back through the last month and identify the source of all of the deposits to your checking account.  Rule #1 states that each of these cash flows was created by an asset.

Here’s an example from our lives.  During the past month, we deposited 2 payroll checks and one bonus check. We also had direct deposits for interest income and a commission payment from Amazon. Given this you should be able to deduce that we have the following assets: cash, internet properties, and ourselves.

The average American gets an semi-monthly infusion of cash from there employer. If every stream of cash is created by an asset, then what is the asset that creates your salary? That’s right. It’s you.

Think about this for just a second. The main asset (and maybe the only asset) in your life is you – your body, your mind, your talents. YOU! Hold that thought and let’s move on to the second rule for a second.

2. Every stream of cash that flows out of your pocket has to be paid for with cash created by an asset.

If you buy a piece of land and do nothing with it, you’ve just purchased something that is going to cause cash to flow out of your pocket in the form of property taxes.  If you took out a loan to purchase the land, more money will flow out of your pocket to pay for interest and to pay back the principal of the loan. The land that you thought was an asset is not really an asset. In fact, it’s making your poorer every single month.

And where does the cash come from to pay for this land that’s making you poorer and poorer and poorer. Oh yeah, back to rule one now. It has to come from one of your other assets. And if you don’t have asset other than yourself to produce the cash, you’re having to work harder and harder to pay for this supposed asset that is actually draining money from your wallet.

What do I do now?

For now, just mull these things over. Figure out what assets you have in your life. Make a conscious decision that you are happy with the assets that you have, or make a conscious decision that you would like to change the assets in your life.

If you only have one or two assets that are creating all of the cash in your pocket, consider what would happen if one of those assets disappeared. Could you do without the cash from that asset?  Do you have insurance that would help make up the difference?

Consider whether your life viewed as a whole is an asset? Does the cash that you earn from working exceed the expenses that you incur to sustain your life?  If you life as a whole is an asset, then you will have cash leftover each month.

And finally, imagine what your life like you want it to be. Then imagine opening up your mailbox and pulling out your monthly bank statement. Open it as you walk back to your house (the house that you want to be living in) and look at the deposit section. Where are the deposits coming from? How big are they? How have you chosen to make money?