The phrase “passive income” has become a buzzword, capturing the imagination of many seeking financial freedom. The allure of making money effortlessly, the dream of earning while you sleep – these concepts have been stated through the advice of countless influencers. The internet is flooded with advertisements and success stories. Amid this hype, one question looms large: “Passive income: is it a scam?”
Key takeaways
- Definition of Passive Income: Passive income is typically defined as earnings from sources where an individual is not actively involved. It is income generated from an asset that does not require a significant amount of active work once set up.
- Attraction to Passive Income: People are drawn to passive income to accelerate wealth building outside of traditional employment, where income is directly tied to the amount of time worked. Passive income offers the potential to earn money with fewer active work hours, making it an appealing option for boosting overall income.
- Effort Required for Passive Income: The notion that passive income can be earned with little to no effort is misleading. Setting up a passive income stream often requires significant upfront work, time, and sometimes money. Maintaining these income streams also requires ongoing effort.
- Reality vs. Perception: The misconception that passive income is a “set-and-forget” approach leads many to become disheartened when they realize the amount of upfront work involved. Passive income also requires creating a system or having sufficient capital to invest initially.
- Legitimacy of Passive Income: Passive income itself is not a scam; it is a legitimate way to earn money. The scam lies in the unrealistic portrayals by some individuals who claim it can be achieved effortlessly, often charging for access to their “secret methods” which may not be effective.
What is passive income?
One definition of passive income is “earnings derived from a rental property, limited partnership, or other enterprise in which a person is not actively involved.” [1]
More recently, passive income has been more loosely defined as “any money earned in a manner that does not require too much effort”. [2]
More generally described, passive income is income that is generated from an income-producing asset that doesn’t tie an individual’s work time directly with the income. This is where the term, “earn while you sleep”, comes from.
However, a certain amount of effort is still required, with different types of passive income requiring different levels of effort. This will be explained in more detail below.
Other income that has been grouped into passive income sources comes from what is commonly termed “side hustles”. Some examples include:
- displaying digital advertisements on blog sites and social media platforms,
- renting equipment and space such as a spare bedroom or garage space for storage,
- selling digital products online such as books, courses and memberships.
In each of these examples, a product or service is created or made available and then earns recurring income with minimal additional work.
Why are people attracted to passive income?
The primary reason people are attracted to passive income is to accelerate wealth building outside of the usual earning method of working as an employee of a company.
Working as an employee of a company is effectively trading your time for money. The income earned as an employee is known as active income.
Since we have a limited amount of time each week at the workplace, there are limits to how much can be earned in this way.
Realistically, people could work for up to 10 to 12 hours per day and 6 days per week. Any more than that and an individual will likely burn out. Working up to 72 hours per week for a fixed rate limits the maximum amount of income that can be earned.
Methods for earning passive income make it possible to boost traditional income. Passive income can be earned with fewer active hours of work once set up.
This often involves setting up a system whereby you can continue to earn money while not actively working. Alternatively, you could work for fewer hours than in a typical “9 to 5” job.
How passive income is portrayed
The way passive income has been touted as a way to earn money without having to put much effort into setting it up is not entirely true. All forms of income require a certain amount of work and time to establish and maintain.
You may have read articles, or watched content online, and were motivated to try some of the ideas for earning passive income. Many people realise after starting that it does require a certain amount of up-front work, or money (usually earned as active income), and they become disheartened and give up.
Whilst passive income is an attractive option for earning money, there is a misconception many people have about how it works. The idea of passive income being a set-and-forget approach is what makes it seem so attractive. In reality, a certain amount of work is needed to create a system or to have enough money to put towards earning passive income.
Often, earning passive income is a lot more work than first expected. A couple of examples are given below to explain this in more detail.
Examples of passive income
Example 1: Chloe plans to write an e-book and sell it online, and likes the idea of writing a book once, and selling it many times to earn money with minimal effort after it is published. She will need to spend her own time writing it, which may take months or even more than a year depending on how much free time she has to work on it. She may then ask her family and friends to read it and critique it. It could take a few iterations before it is ready to publish.
During this time, Chloe worked hard while not earning any income. Once published, she may need to advertise the book to get sales and improve its ranking. This will cost her money that she will need to pay out of her pocket. Passive income will only be realised when the book is purchased. In this case, a lot of time and effort will be required before Chloe earns passive income.
Example 2: Michael would like to earn passive income through a rental property. He will need to save for a downpayment to purchase the property. If Michael already owned a property that he lives in and has paid off a portion of the mortgage, he may be able to use the equity in his property to help fund the downpayment. There are also legal costs and government fees associated with purchasing a property.
Once Michael has purchased an investment property, he may need to pay for repairs before it is ready for tenants to move in. Rental properties then have ongoing costs such as mortgage repayments, utility costs, insurance, and maintenance and repair costs. If a real estate agent is used to manage the property and collect rental income, the costs increase further. The total rental income must exceed the total costs and fees of owning the rental property before passive income is earned. Over time, the value of the property is likely to increase. However, this is not immediate income and is only earned when the property is sold.
These real-world examples show that earning passive income usually takes time and/or money. It also often takes a significant amount of upfront work.
The answer to passive income: is it a scam?
The short answer to the question, “Passive income: is it a scam?” is: no.
Passive income itself is not a “scam.” It is a legitimate form of income and many people successfully earn income passively.
Warren Buffet once said, “If you don’t earn money while you sleep, you will work until you die.” This is one of the most important aspects of passive income.
Active income involves trading your time for money, which means if you don’t work, you don’t earn money. Passive income allows you to earn money whether you are working or not. It effectively breaks the bond between time and money!
The scam is based on people (“gurus”) who give false hope to others. They make out how easy it can be to make passive income and are not realistic about how it works and how much up-front effort is needed.
In addition, these gurus often convince people to subscribe and pay money to learn more about their “secret methods” to becoming wealthy through passive income.
In reality, these scammers often make more money from their subscribers than the actual passive income method they are promoting.
By now you might be asking, “So, what are some examples of passive income? How can I start earning passive income for myself?” The next section will answer these questions.
Sources of passive income, and how “passive” they are
An informative article written by the Financial Samurai [3] ranks several types of passive income sources based on risk, return, feasibility, liquidity, activity and taxes.
The table below summarizes the different passive income sources in order of lowest to highest score. The “activity” rating indicates how much active work is required to start and/or maintain the passive income stream, with 10 being the least amount of work. The higher the score, the better the passive income source.
In the two examples given earlier, Chloe has chosen to create her own product (an e-book, ranked as the fourth-highest score in the table), while Michael has chosen the physical real estate option (purchasing an investment property, ranked as the third-highest score).
The top three sources of passive income in the table are:
1. Dividend investing
Dividend investing involves purchasing equities (shares) in companies or funds that pay dividends at regular intervals. Most dividend-paying equities allow investors to reinvest the dividends to help grow the investment at an accelerated pace.
This passive income source ranks highly on feasibility (it is easy to set up a brokerage account and purchase equities), liquidity (it is relatively easy to sell equities and have the money returned to your account within a few days), and activity (it only requires investors to purchase the equities and requires little effort after that).
Dividend investing scores lower on risk and returns based on the potential volatility of equity markets.
2. Real estate crowdfunding (REC), investment trusts (REITs) and exchange-traded funds (RE ETFs)
These passive income sources score highly on feasibility and activity, like dividend investing.
However, they are less liquid than dividend investing because it can take more time to sell the investment.
3. Physical real estate
Owning an investment property has tax benefits, and scores well on the risk and return metrics.
The feasibility score is lower than the other two above because purchasing a property requires more money upfront. Liquidity scores lower as it takes more time to sell property compared to equities.
Finally, the activity score is lower as investment properties require more work to set up and maintain.
Final thoughts
Whilst earning passive income is a legitimate and common income option, it does require a certain amount of upfront effort. This usually involves earning money actively to save and eventually invest in, or put money into, the passive income source.
Some scammers give people false hope in earning money passively while they “relax at an island resort drinking cocktails.” The saying, “If it sounds too good to be true, it usually is,” applies here.
Do your research before paying for a subscription to someone who states you can earn passive income with little effort.
Leave a comment below if you earn passive income from one of the sources listed above, and how you achieved it. If you earn passively from a different source, let us know!
FAQs
1. What is passive income?
Passive income is earnings derived from an asset or business in which an individual is not actively involved. Examples include rental income, dividends from investments, and royalties from creative works. It is income generated with minimal ongoing effort after the initial setup.
2. Why are people attracted to passive income?
People are attracted to passive income because it offers the potential to earn money with fewer active work hours once set up, thus accelerating wealth building. It provides a way to supplement or even replace traditional income and offers financial flexibility and security.
3. Is passive income really effortless?
No, passive income is not entirely effortless. It requires significant upfront work, time, and often money to establish the income stream. Maintaining these income sources also requires ongoing effort, although it is generally less than active income sources.
4. Can passive income be considered a scam?
Passive income itself is not a scam; it is a legitimate way to earn money. However, the scam lies in the unrealistic portrayals by some individuals who claim it can be achieved effortlessly and often charge for access to their “secret methods.” It’s essential to approach such claims with skepticism and do thorough research.
5. What are some common examples of passive income?
Common examples of passive income include rental properties, dividend investing, real estate crowdfunding, writing and selling e-books, and displaying digital advertisements on websites or social media platforms. Each of these requires initial setup and ongoing maintenance to generate income.
6. How can I start earning passive income?
To start earning passive income, identify an income source that aligns with your skills and resources. This could be investing in dividend-paying stocks, purchasing rental property, creating digital products, or participating in real estate crowdfunding. Be prepared to invest time, effort, and possibly money upfront to establish your passive income stream.
References
| ↑1 | Passive Income: What It Is, 3 Main Categories, and Examples (investopedia.com) |
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| ↑2 | https://corporatefinanceinstitute.com/resources/accounting/passive-income/ |
| ↑3 | Ranking the Best Passive Income Investments/ (financialsamurai.com) |
