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Nothing Beats Experience
Crash Test Money is all about learning through experience.
Generating passive income is not easy, and my efforts have been met with mixed results.
My biggest lesson so far is that every passive income idea involves some level of effort and cost. There is no guarantee you will make money. It is very easy to lose money through passive income if you do not make enough money to cover your costs or you hold investments that decline in value.
Through trial and error, I have come across four passive income ideas that pretty much anyone can do with the right amount of effort and research. They are:
- High-Yield Savings Accounts
- Bonds
- Dividend Stocks
- REITs (Real Estate Investment Trusts)
Before we dive deeper into these passive income ideas, let’s look at what passive income is and is not.
What is Passive Income?
Passive income is when you generate money from activities needing minimal effort or active involvement. It is a type of activity that continues to generate money even when you are not working. Examples of passive income include rental properties, dividends, online businesses, affiliate marketing, and many more.
You can use passive income to generate income streams alongside your primary job. This may lead to greater financial flexibility. Passive income can be a financial cushion during emergencies such as job loss or a costly repair. It can also help build an emergency fund, pay off debts, finance home projects, or make investments.
Passive income is ideal because it allows you to earn extra money from anywhere. You do not need to drive for a ride-sharing company or deliver food in your spare time. Instead, you can earn passive income from the comfort of your home.
What Passive Income Is Not
Passive income is not a get-rich-quick or miracle cure for your financial hardships. You may not even make enough money to buy a coffee at your local coffee shop. Chances are you have a better chance of winning the lottery than striking it big with passive income.
So, passive income may not be enough if you are relying on it to cover living expenses. Often, getting a second job or side hustle may be a better option. Unfortunately, you may need to hold onto your full-time job and get a second if you want to earn extra money.
Also, passive income is not as simple as many people make it out to be. One of the biggest passive income myths is it is effortless. Nothing can be further from the truth.
Passive income can involve a lot of sweat and tears and be highly challenging. In the end, you may have nothing to show for it. You can spend hours, weeks, or months writing the most masterful ebook that no one buys. That same goes for any other passive income stream that involves creating content. If no one clicks, then there is no money.
4 Time Tested Passive Income Ideas to Make Money
Now that we know what passive income is and is not, let’s look at four tested strategies that can make you money. But before we begin, let’s examine one crucial factor they share.
It Takes Money to Make Passive Income
Generating large amounts of passive income through high-yield savings accounts, bonds, dividend stocks, and REITs requires time and money. Most of these passive income streams will yield around 4% per year. 4% on a $100 will only generate $4 a year. A larger investment of $10,000 at 4% will only generate $400.
I am not trying to discourage you, but it’s essential to have realistic expectations. Passive income is not a get-rich-quick scheme. It will not happen overnight unless you have a lot of cash, which is not a common situation for most people.
To make money with these passive income ideas, you need to keep investing. This will allow you to increase the size of your investments and lead to more passive income. So, if passive income is your goal, you need to make a plan and be patient.
Alright, now that we’ve got that out of the way, let’s review the first passive income stream on our list.
1. High-Yield Savings Accounts
A high-yield savings account is a type of savings account that offers a higher interest rate compared to traditional savings accounts. Online banks often offer the best rates since they can provide higher interest rates due to lower overhead costs.
PROS
A high-yield savings account is a simple and easy way to generate passive income. They are safe and low-risk passive income streams as long as they come with FDIC or NCUA insurance. High-yield savings accounts are easy to set up and require very little maintenance. At the end of each month, you’ll earn interest on your balance. That interest will be deposited directly into your account and continue earning interest.
CONS
The rates on high-yield savings accounts are variable and will fluctuate. When inflation is running high, you will earn a decent rate of return that can exceed 4% or higher. But, during periods of low inflation, the interest rate you earn can drop well below 1%, resulting in minuscule amounts of passive income. Therefore, you need to track interest rates and be ready to move your money if rates drop too far.
EXPERIENCE
Opening a high-yield savings account is easy if you are opening it online. It took me about 15 minutes. After that, transferring money to your account is a simple process. Then you are off to earning passive income.
There are many good options when opening a high-yield savings account. The big national banks are not one of them. They are still offering pathetic rates at a fraction of a percent. The big national banks also tend to have minimum balance requirements and make you jump through hoops to avoid fees to get that pathetic rate. But, you also need to be careful with online banks.
Read the fine print before you sign on with online banks with funny names offering sky-high rates. There may be several strings attached to earn the higher rate.
They may require minimum balances of thousands of dollars.
Another common practice is offering you a higher rate on the first few thousand dollars. Then you get a subpar rate for anything above that threshold.
I chose to open a savings account with Discover as it struck the right balance for me and my situation. They are a well-established company that offers a competitive interest rate. They have no monthly fees and no minimum deposits or monthly balance requirements.
No matter which bank or credit union you choose, ensure it is FDIC or NCUA insured and read the fine print before signing up.
2. Bonds
Bonds are debt securities typically with fixed interest rates and repayment terms. But, some bonds do have variable rates. Corporations and governments issue bonds to raise money for things like new projects, buildings or to pay debt.
Credit rating agencies evaluate the creditworthiness of issuers and bonds. They use a standardized credit rating scale to determine the likelihood of default and the risk to investors. This scale ranges from investment grade, which includes the most creditworthy issuers and bonds, to non-investment grade. Non-investment grade or junk bonds are risky and have a greater chance of default.
PROS
Bonds are an ideal passive income stream because they are predictable and reliable. Investors receive regular interest payments, usually twice a year, and are repaid the principal balance at maturity. They are also easy to buy through investment brokerage companies or direct from the government at TreasuryDirect for US treasuries.
You also have several options you can use to invest in bonds. For instance, you can buy individual bonds or bond index funds, mutual funds, and bond ETFs. You can also create bond ladders, which are like CD ladders.
CONS
The difficulty increases once you move into bonds to earn passive income. You are not in Kansas anymore, and the learning curve is steep. Purchasing bonds requires a thorough understanding of how bonds work. Controlling risk also becomes a significant factor. Not only is your passive income at stake, but also your principal balance.
The main challenge is there are many bonds and bond funds to choose from, and they are not all created equal. If you buy individual bonds, you can be stuck with that choice for a long time.
Furthermore, It is challenging to strike a balance between risk and reward. Chase yield only, and you can stare at default, kissing your passive income and principal balance goodbye. Go to secure, and you might not make enough interest to warrant using bonds for passive income.
You also have interest rate risks to worry about. When rates go up, bond values decrease, and when rates go down, bond values increase. So, you can lose money if you decide to sell your bonds when rates are high.
EXPERIENCE
Experience has taught me to take my time and research my investment options. You also need to know when to call for help and consult a financial professional. I spent a lot of time researching bonds and settled on I bonds.
Back in 2022, I Bonds offered impressive interest rates of over 9%, backed by the full faith of the US government. That was as close to a no-brainer as I could get.
The downside of I bonds is that their interest rates fluctuate every six months. The bonds I bought in April with a yield of over 9% now offer less than 5%. I Bonds also require a minimum one-year holding period, and there is a 3-month penalty if I sell them before five years.
As you can see, there is no such thing as a free lunch when it comes to investing.
3. Dividend Stocks
A company can decide to share some of its profits as dividends, but not all companies pay them. The dividends you receive depend on the company’s earnings and the number of shares you own. Dividends are often distributed quarterly and can provide a reliable source of passive income. You can also reinvest the dividends by acquiring more shares. This will lead to a larger dividend payout in the future.
The amount of the yearly dividend payout will show as a percentage called the dividend yield. The dividend yield is the dividend-to-stock price ratio, which will fluctuate.
For instance, if a company has a yearly dividend of $1 per share with a stock price of $20, its dividend yield is 5% (1/20 = 0.05 or 5%). If the stock increases to $40 per share, the dividend yield will drop to 2.5% (1/40 = 0.025 or 2.5%).
PROS
Dividends can be a great source of passive income as the only requirement is to own shares in a dividend-paying company or fund. Once you make an initial investment, you will receive dividends at each payout. The best dividend stocks have a record of increasing their dividends over time.
CONS
Like with bonds, choosing the right dividend stock or fund is the biggest challenge. So many choices make the selection process challenging and adds significant risk. If you decide based on dividend yield alone, there is a good chance you will get burned.
Remember that a high dividend yield may result from a significant drop in stock price. Also, there is no guarantee that a company will continue to pay dividends. This can happen when a company finds itself in financial trouble. So, it is important to have a certain level of risk tolerance when you invest in dividend stocks.
EXPERIENCE
I know the pain of buying a dividend stock only to see the dividend slashed and the stock price plummet. This is what happened to me when I bought shares of Alcoa after the great recession.
When I purchased Alcoa stock, I thought I was picking a reliable dividend stock on the cheap. Better yet, it was a blue chip company listed on the Dow Jones for over 50 years.
I made a bad choice, and my investment and dividend payouts suffered. Within months Alcoa slashed its dividend and was booted from the Dow Jones after a 54-year run. Then an activist investor set off a board battle ending with Alcoa splitting into three separate companies.
When it comes to passive income, you want investments that will be stable and reliable. Picking individual stocks is hard. So, index funds, mutual funds, and ETFs specializing in dividend stocks may be a better option. A single fund will diversify your holding across many dividend stocks. This will limit your risk of making a bad pick with individual stocks.
4. REITs
A REIT stands for Real Estate Investment Trust. They own, operate, or finance income-generating properties. You can buy publicly traded REITs like any other stock. This makes them a great way to invest in real estate without needing to buy and maintain properties.
They are very similar to other dividend stocks. The biggest difference is that REITs must pay out a minimum of 90% of their taxable income to shareholders through dividends. Due to the required payout, REITs often have higher dividend yields making them a solid option for people looking for passive income.
PROS
Much like other dividend stocks, REITs can be an excellent source of passive income. You only need to own shares to receive dividends. Once you make the initial investment, you will receive dividends at each payout. You can deposit the dividends into your brokerage account or reinvest them in the REIT. Reinvesting the dividends will increase your dividend payout in the future,
CONS
A REITs cons are almost identical to dividend stocks. The most significant challenge is choosing the right REIT. If you base your choice on yield alone, your dividends and investment may vanish. Also, the size of your dividend payment will change based on profit. A struggling REIT may cut or suspend its dividend.
EXPERIENCE
My experience with REITs ranges from safe and reliable to borderline speculative plays.
My “safe” play is Reality Income Corp. It is a large and diversified REIT. It is among the few companies offering monthly dividend payouts. Better still, Reality Income Corp has achieved the esteemed status of a dividend aristocrat. To earn this title, a company must have raised its dividend annually for 25 consecutive years or more.
Remember how I keep saying do not chase yield?
Well, that is what I did when investing in mortgage REITs. I am investing in mortgage REITs for their high dividend yields that often exceed 10%. So far, I have been burned.
Mortgage REITs are highly leveraged REITs that focus on mortgages and mortgage-back securities. Since they are leveraged and hold debt, inflation has not been kind to these companies. I have seen my dividends cut and the stock value drop. Even a double-digit dividend cannot compensate for the stock price slide.
This is why picking individual REITs, stocks, and bonds can be risky. You can reduce that risk by buying funds that specialize in REITs, much like you can do with bonds and dividend stocks. This can give you diversification across several REITs without holding individual REITs.
Putting it All Together
I hope my experience with these four passive income streams provides valuable insights. As you can see from my experiences, these are all easy to set up. But, there are risks and challenges associated with each. The biggest challenge is choosing the best option. Often, a specialized fund with many holdings, such as index funds and ETFs, might be your best choice.
So, take time to research your options. If your goal is passive income, then you need to watch the level of risk you are taking on. You want to avoid high levels of volatility.
When in doubt, you may want to consult with a financial professional to determine what is right for you.
Any mention of a particular company or stock in this post is for informational and educational purposes only and is not intended as a recommendation to buy or sell a security. Do your due diligence and if needed, consult with a professional before investing in any financial security.
