“If you don’t find a way to make money while you sleep, you will work until you die.” – Warren Buffett
Almost every other online article these days extols the virtues of being an entrepreneur. While the current US economy is still doing well, wages are stagnant, and many individuals are turning to side gigs to make ends meet or get ahead financially. The problem is that when you work for wages, even when working for yourself, you’re trading your time for money. And as most of us have learned, it’s a trade-off: you can have money but no time, or time but no money. But what if you could increase your income without having to spend the time to do it? Hello, passive income.
What is Passive Income?
Passive income is often a loosely used term. Many people define it as any money earned regularly with little to no effort on the part of the person receiving it. Some of the most popular ways of generating passive income include rental income from real estate, interest income from peer-to-peer (P2P) lending, and dividends received from owning shares of dividend-paying stocks. Here are the pros and cons of each approach to consider.
Pros: You can buy a property at a good value and then fix it up to rent out. While you hold the property, the asset value and owner’s equity typically (but not always) increase as you pay down the loan. And there are still some sweet tax breaks for property owners: mortgage interest, property taxes, insurance, maintenance and upgrades, and management fees. If these expenses exceed your rental income, you can deduct them to reduce your total tax bill.
Cons: Being a landlord comes with a full set of challenges and responsibilities. You’ll have to find the right property at the right price, get financing, and find stable tenants who will take reasonable care of your property. Don’t forget maintenance headaches—at some point, you’ll likely be getting calls about clogged toilets, broken pipes, or will need to replace major items like HVAC systems. Then there are the many laws that come along with renting your investment to tenants, along with quarterly taxes.
Peer to Peer Lending
Pros: P2P lending is an attractive alternative to traditional investment choices such as stocks, bonds, CDs, or real estate, and allows you to receive monthly payments of principal and interest as borrowers repay their loans. It’s easy to open a P2P investment account online, and the initial investment in each loan you decide to fund can be as low as $25. P2P lending allows you to diversify your risk across multiple types of different loans. You can choose how much risk you are willing to take by selecting which loan grade to invest in. Similar to stocks, lower-grade loans offer a greater risk but yield higher interest, and higher-grade loans offer low risk but pay lower interest. You can also decide whether to reinvest the income you receive into additional loans, or withdraw it to spend or reinvest elsewhere.
Cons: Potential disadvantages to P2P lending include the risk of losing all your money if a borrower defaults. It does take some initial cash investment to make enough small loans across multiple borrowers to diversify risk, just like other types of investments. Experts recommend avoiding only high yield loans unless you’re prepared to assume the high risk that comes with that approach. To properly diversify across multiple risk levels, you’ll need to invest in about 125 to 175 loans, which can get expensive quickly.
Another potential disadvantage is that it’s not liquid—you’re stuck with the loan for the stated term, which can be up to five years. You can’t sell the loan, which makes it more similar to a fixed-income type of investment.
Pros: Dividends provide a predictable income stream. Like rental income, dividends pay a known amount on a set date. Instead of periodically selling stock to generate regular income, dividend investing allows you to keep a stock’s initial investment value while also generating truly passive income. Dividends are cash that can be withdrawn, or accumulated and reinvested into the portfolio’s stocks. Automatically reinvesting a company’s dividends through a DRIP (dividend re-investment program) can quickly compound dividend income over time.
There are dividend-paying stocks in every industry and market sector, including real estate. An entire portfolio can be constructed around dividend payers using a smart beta* approach, which offers an above average dividend yield with lower than average market risk (beta), compared to mutual or index funds**.
Another advantage is that dividend stocks pay income regardless of market ups and downs; in effect, you’re getting paid to hold the stock no matter what the market is doing. Companies with safe, reliable cash flows and a history of paying dividends are more likely to offer steady future dividends. Because companies that pay dividends tend to be more financially stable, their stock prices and dividends tend to increase over time, as their perceived investor value continues to grow.
Cons: Investing in individual companies requires research, due diligence, and monitoring, along with appropriate portfolio construction to mitigate risk—something many investors just don’t have the time or patience to perform themselves. Dividend stocks tend to grow slowly because they are more likely to be established companies in mature industries, although there are exceptions. An example of an exception is dividend growth stocks, which offer a low yield but have the potential to increase considerably as their earnings grow and can keep up with inflation.
Monitoring is especially important because blue chips can and do fail (remember Eastman Kodak or Enron?). If a company’s earnings decline over time, the dividend policy may change and the dividend can be cut. In addition, buying and selling individual stocks costs investors broker commission fees, which can add up and reduce returns. If you are interested in dividend investing but don’t have the time to do all of this (and it’s quite a time investment to do effectively), Emperor Investments is a good option for you.
Investing in any type of passive income approach comes with some degree of risk. All require some amount of research and take time to grow into an income stream that can supplement or replace your day job. But understanding the positives and negatives of each approach is a good first step to figuring out which one is right for you.
Martha Brown Menard, PhD, is a research scientist, financial coach, and dividend income investor. She takes a smart beta approach to building her own portfolio, and likes seeing her income stream grow.
* Smart beta investing combines the benefits of passive investing and the advantages of active investing strategies. The goal of smart beta is to obtain alpha (aka “excess return” or return +/- anticipated return), lower risk or increase diversification at a cost lower than traditional active management and marginally higher than straight index investing.
**Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
***Emperor Investments does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.