Most of us work every day and receive a paycheck every week or few weeks. This is called active income. Some people, however, are both lucky and smart enough to spend their time working to create residual income streams.
Residual income (also known as passive or recurring income) refers to earnings that you continue to receive even after the work required is done. There are lots of different ways to build residual income, and can include anything from investing in real estate to earning royalties from the sale of a song. Below we’ve outlined seven of the most popular ways to build earnings that you continue to receive long after the work (or investment) is done:
1. Invest in dividend stocks or index funds
One of the most well-known forms of residual income, holding stocks can be a great tool for earning regular income, as most companies pay dividends (a portion of a company’s earnings paid to investors) on a quarterly basis. Suppose you buy one share of Company ABC and they pay an annualized dividend of $1 per share. Assuming Company ABC pays dividends quarterly, you would receive a check for ¼ of $1 (or $0.25) every quarter.
Ample research is required to identify strong companies and, as our example above shows, dividend investing often requires a substantial investment to receive large checks. However, consistently investing into a diversified pool of dividend stocks can help you amass sizeable residual income over time.
Index funds are another way to get exposure to regular dividends. An index fund is a mutual fund with a portfolio constructed to match a market index. Index funds are known for providing broad market exposure and tend to outperform most individual stocks. Investing in an index fund based on the S&P 500 Index, means that you are investing in the overall market, without needing to pick individual investments or worry about buying and selling individual companies.
Both individual dividend stocks and index funds are best accessed through an online broker. See Barron’s 2015 Best Online Broker Ranking for a comprehensive list of different brokers and their fees.
2. Allocate funds to a robo-advisor
Arguably the next evolution of dividend stocks and index funds, a robo-advisor is an online service that provides automated financial portfolio management and rebalancing, without the use of human financial planners. As Jeff Rose of personal finance site Good Financial Cents put it, “putting money into an account and letting an algorithm manage the investments is about as passive as you can get.”
Popular robo-advisors include Betterment, Schwab Intelligent Portfolios, and Wealthfront, all of which ask you to select your tolerance for risk, investment goals, etc. in an effort to best manage and balance your account. The fees are very reasonable and much less than with an account managed by a person. As a bonus, because robo-advisors rely on technology rather than humans to manage investor portfolios, the fees tend to be much lower than those of traditional financial advisors.
3. Add real estate to your portfolio
Real estate has become one of the most popular ways to secure residual income. Traditionally, building a residual income stream through real estate, whether commercial or residential, has required a large upfront investment, both of time and money, but thanks to new investment vehicles those interested in earning passive income through real estate have several options to choose from:
An investment property is an asset purchased with the sole purpose of earning revenue. Income from an investment property can be generated through leasing space within an asset or an eventual sale.
Owning an investment property can result in both potential appreciation value over the long-term and direct tax benefits of depreciation. However, acquiring an investment property often requires a large upfront investment ($100K to several million dollars depending on the type of asset) and lots of hands on work. Furthermore, as with any investment, investment properties carry the risk of large, unexpected, and costly problems, which many investors do not have the experience or time to effectively handle. An investment property is relatively illiquid—meaning you can sell at any time, but the sale process can often take months and may be unsuccessful.
New Technology Platforms
In the past few years, new platforms have emerged that use technology to make the process of real estate investment more efficient, resulting in increased transparency, lower fees, and higher returns. As the broader financial technology (FinTech) space grows, more and more investors are moving to online platforms that give them more control over their finances and take advantage of the efficiencies that transacting on the web can offer.
These companies aim to offer the benefits of public market access, but with lower fees that potentially help investors earn better returns. Fundrise, one of the pioneers in the space, has leveraged both technology and new federal regulations to offer investors the first ever low-fee, diversified commercial real estate investment available directly online to anyone in the United States, no matter their net worth.¹
However, it’s important to remember that every platform uses a different set of due diligence criteria to determine what investments it offers its members and, as with any investment, investing in real estate through an online platform carries significant risk.
Private Equity Funds
A private equity (PE) fund is a collective investment fund that pools the money of many investors to invest in real estate. Private equity funds often consist of several different investments, which increases diversification for investors. Additionally, PE funds are often managed by real estate experts with very rigorous underwriting standards.
Traditionally private equity fund investments are illiquid and carry high investment minimums. Private equity funds are often formed by institutional investors and high worth individuals with a “two and twenty” fee structure, meaning a 2% annual asset management fee, and 20% of any profits earned by the fund.
Real Estate Investment Trusts (REITs)
In 1960, Congress passed a law creating Real Estate Investment Trusts (REITs), large portfolios of income-producing real estate. A REIT is required by law to distribute 90% of its earnings to investors each year. Today, an estimated 70 million Americans invest in REITs. Due to their special tax status, REITs must follow strict compliance standards and thus carry a certain quality standard for both the vehicle’s investment strategy and the real estate experience of the managing team.
There are two primary types of public REITs: traded and non-traded. Traded REITs offer the benefits of being traded openly on an exchange, giving investors liquidity. However this liquidity is likely to be priced into the value of the shares, resulting in a “liquidity premium” or lower relative returns for all investors, regardless of whether or not they choose to sell their shares. Furthermore, traded REITs tend to be correlated to broader market volatility, meaning that the value may fluctuate depending on how the stock market is doing, regardless of whether or not anything has changed with the underlying properties owned by the REIT.
On the other hand, non-traded REITs have become more popular because of the perceived consistent double-digit dividends. However, non-traded REITs have recently come under heavy scrutiny because of the large upfront fees often charged to investors—and dubious practices around the disclosure of those fees.
4. Invest in a company as a silent partner
Taking a minority stake in a business can enable you to participate in the company’s potential profits (and losses) without having to handle day-to-day operations. Until recently this process had been handled offline where potential investors had to seek out companies through their own personal networks. However, the advent of sites like AngelList and Crunchbase have given investors the ability to search for interesting companies in all sorts of industries. Furthermore, platforms like CircleUp and OurCrowd allow for the entire investment process—from sourcing to funding to reporting—to take place online.
5. Become an online lender
Peer-to-peer, or marketplace, lending allows individuals to borrow and lend money online—without going through a traditional bank. The current market is dominated by Lending Club and Prosper. After placing a loan—which requires both money and time to make sure you feel comfortable with the terms—a lender receives regular interest payments (typically on a monthly or quarterly basis).
Just like a bank, individual lenders are presented with potential loans to fund and can spread investments across dozens or even hundreds of borrowers which helps to mitigate risk. This online, more direct loan tends to be much easier for borrowers to secure than a traditional bank loan. However, one downside is that this model often attracts borrowers who were unable to secure a conventional bank loan.
6. Buy Certificates of Deposits & Annuities
Typically issued by commercial banks and ensured by the FDIC, a certificate of deposit (CD) is a savings certificate with a fixed interest rate. Whereas you can withdraw funds easily from a savings account, with a CD you commit to keeping your funds with the bank for a defined time period. The longer you commit to keep your money with the bank—the higher the interest rate you’ll earn.
CDs are a great way to safely earn passive income, especially for risk averse investors. However, as a result, interest rates tend to be fairly low. As of late February, the average interest rate on a three-year CD from a bank was 0.49%. To increase returns, many investors “ladder” CDs from banks in various time increments to achieve higher returns while ensuring regular repayment of capital. Annuities, on the other hand, are a type of insurance product that require regular payment upfront before paying out a regular stream of payments at a later point in time. Originally, annuities were created to be a reliable way to provide income for retirees and to alleviate fears of outliving one’s assets.
7. Consider investing your time rather than money
Above we’ve mentioned several different ways to begin to build a residual income stream that all involve an upfront monetary investment. However, there are lots of ways to earn residual income that involve time rather than money. A few of these include earning royalties from the sale of stock photography, a song, or an e-book and developing and monetizing a blog with ad sales and affiliate partnerships. The College Investor has a comprehensive list of ways to build residual income that involve an investment of time rather than money.
One caveat: earning residual income is not easy. There’s a reason most Americans still depend on active income. Furthermore, building residual income always requires some sort of upfront investment - whether in time, money, or both.
Regardless of which avenue you decide to pursue to earn residual income, take your time to figure out which approach makes the most sense for you and your savings goals and remember that diversification into different asset classes and income types is one of the most effective ways to build unique streams of residual income, and, most importantly, a profitable portfolio!