Why it pays to have a passive income

Why it pays to have a passive income

When I first started to think about retirement more than 10 years ago, I asked myself: How much do I need to save by the time I stop working so that I can live comfortably for the rest of my life?

However, I realized that targeting a specific amount of savings for retirement is very challenging.

A lot of difficult questions needed to be answered: How much will I be spending by the time I retire? Will I completely stop earning and just spend all of what I’ve saved until I die?
Up to what age will I live? How much more should I set aside so that I will still have enough in case I get sick or live longer than expected?

Planning for retirement only became easier when I started to think about how much passive income I needed to generate to maintain my current lifestyle. It also changed my priority from merely saving enough to accumulating assets that would generate enough income to support my spending habits in the future.

Having a stable, passive income is very important.

Similar to having a paycheck, the assurance of receiving something on a monthly, quarterly or annual basis gives us the confidence to spend, either for our necessities or our wants, or even to generously help others including family, friends and charities.

Active traders and entrepreneurs also stand to benefit from having a stable source of passive income on top of what they earn from trading or their businesses. It helps them become more objective and less emotional in deciding whether or not to buy a stock or to pursue a business deal.

Even rich people who have a lot of excess funds stand to benefit from having passive income. It puts them in a better position to take advantage of rare investment opportunities that provide significant future returns like buying deeply undervalued stocks during bear markets, distressed properties during economic downturns, or promising startups in the infancy stage.

The most common way to generate passive income is by investing in bonds. Given falling rates, however, it’s now becoming more and more difficult to generate enough passive income by simply investing in bonds.

Another investment that generates passive income is dividend-paying stocks.

Similar to bonds, dividend-paying stocks pay cash dividends on a regular basis, either quarterly, semi-annually or annually. They are just more volatile and returns are not guaranteed.

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Nevertheless, capital appreciation potential is more attractive compared to fixed income instruments. The dividend yield of these stocks are also higher compared to bond yields.

Now is also a good time to buy these stocks since many of them are currently trading at attractive valuations. This allows you to enjoy significant capital appreciation in the future in case you decide to sell them.

It is important to pick stocks that belong to defensive industries that are still growing. In the Philippines, these include stocks in the power and telco industries and consumer staples. Cash dividends in these defensive industries remain stable even during times of economic downturn, and continue to grow over time.

Another popular investment that generates passive income is rental properties. Although more capital is needed, buying properties has now become more and more affordable thanks to the increasing availability of attractive payment terms being offered by property developers and banks.

Moreover, you can start earning income from these properties even if they are not yet fully paid, helping you pay your monthly amortizations. In fact, in some rare cases, there are rental properties that can generate enough income to make them self-liquidating.

Finally, even if you have not yet fully paid for the property you bought, you stand to benefit from any capital appreciation since you have already locked in your purchase price.

Some caveats, though. For residential properties, prices have gone up significantly the past few years while rental rates have hardly moved, bringing down yields.

The amount that you can borrow from the bank is also limited and is largely dependent on your salary and the term of your loan, so you need to take that into consideration when choosing a property to buy.

Mortgage rates also change and can become higher so it might be wise to lock in a longer term rate to reduce uncertainty. You also need to do some legwork or hire an agent to lease out your property and there will be times when your property will be vacant.

Finally, properties sometimes need repairs before they can be leased out. Thus, having a cash buffer is important. 

A final tip: While you are still working, it is important to continue setting aside at least 20 percent of your salary for investments.

Reinvest bulk of your passive income and resist the temptation to upgrade your lifestyle. That way, you can reach your passive income goal faster and have the option to retire earlier.