Thursday, December 5, 2013

Passive Income

Many of the personal finance bloggers out there have a common goal: early retirement/financial independence. Most of them know that to achieve their goals is to have some sort of passive income.

There are two common passive income sources utilized by early retirees: rental properties and dividend stocks. Both require a fairly large one time investment.

For rental properties, of course, it will be the cash payment or the mortgage payments you have for the house which will be used to generate cash flow. Property values tend to remain fairly stable, and has potential to appreciate.  Being a landlord is probably not as easy as it sounds. Everything from maintenance of the property, to rent collection are not easy tasks. Also, selecting a lower taxed but renter friendly property is extremely important. To us, rentals are not a great choice. We are not very familiar with the local real estate market. Our local real estate market also tends to have one of the highest property tax rates in the nation. And finally, we not exactly handy enough to maintain the property ourselves, meaning more operating expenses. So that's a no for us in terms of rentals. Now this might change with JOB Acts (read more here). We might able to use crowd funding to include real estate as a part of our investments. 

Dividend stocks can also generate a fairly stable passive income stream. It does have its shortcomings as well. 
Graph from http://www.multpl.com/s-p-500-dividend-yield/
First, to be able to live off dividends, your base investment will need to be fairly large. Based on the graph below, we are currently at a 1.9% dividend yield, even though the all time average is at about 4%. In order to have about $24,000 of dividends yearly, you are looking at an investment of roughly $1.3M. Or at a 4% dividend yield, we are looking at about a $600k investment. To take the average, we are talking about investing $950k in dividend stocks.
Graph from http://www.multpl.com/s-p-500-dividend-yield/
Secondly, besides the large investment base, stocks have always been very volatile. It has been a great year for stocks and the overall market. The S&P 500 along with many other indexes have reached all time highs more than once and their outlook remains positive for the short term. But for how long?? That is the question we all want to know the answer to. There is a chance of losing the base value. However, a safer bet is to invest in index funds that do provide a dividend. To invest in the market, also known as diversification, can reduce risks greatly. 
Finally, companies can decide to stop paying or reduce their dividend payouts. Even though it will dramatically hurt the company stock price and can be a very costly move to the company, it might still happen. According to Bankrate.com, a record 62 companies in the S&P 500 cut their dividends totaling almost $41B in lost payouts in 2008, and another $30B in early 2009.  

Now, here is another passive income source we currently use and will continue to invest more in: P2P lending.  It is similar to a bank loan but funds are generated from individual investors online. The return averages from 8-12%, if not higher. You do face potential defaults though. However, it is always wise to purchase notes in many loans rather than a single one. We invest with both Lending Club and Proper. It has been great so far. It does tie up your base for a few years, but it easily beats those so called high-yield bank saving/CDs.

We are hoping that with a combination of a few things, we will be able to have a passive income stream to support our early retirement. We do not plan to touch the base investments until much later into our retirement. So what are you doing to prepare your passive income stream?



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