Financial Freedom Quick Tip #36: Cherish passive income
Many people find it difficult to appreciate the value of passive income, because passive income usually come in small amounts.
When people see the small amount of money they will earn from an investment that generates passive income, they often just give it one look, and then decide it is not worth their time.
It’s easy to understand why. When you’re building sources of passive income, especially during the first two or three years, you often have to choose against something really cool that will give you a HUGE amount of instant gratification, browny points and admiration, and instead settle for a little bit of regular passive income, that in comparison, seems very dull.
The table below shows some examples of the nice things you may have to choose against, if you want to build up sources of passive income and become financially free.
| Instant Gratification | Passive Income |
|---|---|
| A brand-new laptop with the latest technology has to offer. | An investment that will earn you about R40 per month, adjusted by inflation on a yearly basis, for the rest of your life. |
| An iPod. | An investment that will earn you about R10 per month, adjusted by inflation on a yearly basis, for the rest of your life. |
| A shiny new car. | A not-so-shiny used car. And an investment that will earn you about R400 per month, adjusted by inflation on a yearly basis, for the rest of your life. |
| Living in a nice, spacious 4-bedroom house. | Living in a modest, 2-bedroom apartment, and using the money you save on rent each year, to make an investment, that will earn you about R100 per month, adjusted by inflation on a yearly basis, for the rest of your life. |
Passive Income and Inflation
Inflation is the percentage of money you’ll need more every year, to buy the same things you were able to buy the previous year. It’s the percentage by which the value of money decreases.
As you can see from the table, the amounts of passive income you can expect to earn from your investments are small. A good investment will usually earn you an average return of between inflation + 2% and inflation + 5%.
In order to keep the value of your investment the same, you can only consider the amount earned over and above inflation, as passive income. The rest of the money should be re-invested to ensure the value of your investment remains constant.
In other words, you can expect your good investments to earn you between 2% and 5% of passive income per year.
E.g. a good investment with a current value of R10,000 will earn you between R200 and R500 of passive income per year, which will increase by inflation every year.
Why cherish it then?
Because passive income is exponential.
In the beginning, while you are building up your initial sources of passive income, it will require you to make many sacrifices and choose against instant gratification often.
However, within a few years (usually between two and five), you’ll be surprised to find that the small bits of passive income have added together to form a significant stream.
As long as you don’t cash in on your investments, that stream of income is likely to remain there – for the rest of your life – whether you do any work or not.
As your passive income stream grows more and more, you will be able make bigger and bigger investments and you won’t have to make as many sacrifices as you had to make initially.
After the first few years
If you can stick out the first few years and build up a fairly good sized stream of passive income, you will eventually be able to use your monthly salary completely to live off – as you are currently doing – and use your passive income to generate more sources of passive income.
In other words, if you can bite the bullet for a few years, you will be able to resume your previous living standard and, in addition, you will start earning an ever increasing stream of passive income, over and above your normal salary.
Fast forward a few more years. Eventually your stream of passive income will grow to be equal to your monthly salary. When this happens, you will be able to stop working and still pay for all your normal monthly expenses. You will be financially free.
It doesn’t mean you should quit your job. It means you have the choice to do so. Your only motivation for still working, when you are financially free, can then simply be the fact that you enjoy what you’re doing.
If this doesn’t sound like a good deal to you, I don’t know what will.
Pay off your debt first
Passive income is the building blocks of financial freedom. Debt is the toddler that marches in and knocks over your little stack of blocks.
Passive income is great and it should be cherished, but if you still have a lot of debt, first make a plan to pay off most of your debts, before you start building your sources of passive income.
This tip is part of the Financial Freedom Quick Tips series. If you want to receive a notice every time a new quick tip is published, you can subscribe to Liberta.
November 19th, 2008 at 09:54 am
Any seggestions on passive income that can be build up with low amount of money
November 19th, 2008 at 09:18 am
If there is one thing that people will start appreciating during this financial crisis is the value of alternate / passive income streams.
You only have to scan the news sites and see the number of jobs being cut – without those alternative income sources, you will find yourself struggling.
November 20th, 2008 at 03:45 pm
@Alvin
Yes, you can build up source of passive income with low amounts of money.
Firstly, any investment can start with a small amount.
You can start by investing a little bit, which will give you only a small return, and invest more and more over a over a few years (e.g. by buying a small amount of shares every few months) until your investments grow into a significant passive income stream.
Secondly, you can use your skills to generate you sources of passive income. E.g., start a website offering useful information about something you have an interest in, optimize it for search engines, and then sell advertising space on your website.
It can be about anything – travel, photography, fishing. This website is an example of that – I have an interest in personal finance, so by building a useful website that offers helpful information to people, and through marketing and optimizing for search engines I can attract more traffic here, and generate an income from selling advertising space.
A website is just one example about how you can use your skills to generate a source of passive income. There are also other ways. E.g., if you have an interest in photography, you can perhaps make an agreement with a photography shop and earn commission from sales from people you referred to that shop.
Hope this helps Alvin.
November 24th, 2008 at 08:37 am
Hi Francois
Baie goeie inskrywing, veral om ‘n balans te vind tussen terugbetaling van skuld en beleggings.