Escape the Rat Race with Passive Income
Building and maintaining a stream of passive income is the only way you can escape the rat race for good. So what is this elusive thing called passive income? Is there really such a thing? How does it work, and is it reserved only for the select few that are wealthy? I want to emphatically say that yes there is such a thing as passive income, and no it is not only for the rich and wealthy.
So how does it work?
Well before I go into that let’s define a few things. First of all. What is an income?
Merriam Webster defines income as: “money that is earned from work, investments, business, etc.” Did you catch that? When most people think about income, most commonly the only thing that comes to their mind is income that is derived from work. Not income that can be derived from business or investments.
So the concept of income is very pigeon-holed into your standard method of “earning wages.” You work a 9 to 5 and you get bi-weekly checks deposited in your checking account. Or you do gigs and part-time work in which case you get paid by the job or by the day.
But passive income is neither of these two things. Now here is where I need to point out that there’s two groups of people that are able to obtain passive income. There are those who come from generations of wealth (old money), where extraordinary amounts of money is passed down from generation to generation. This first group of people rarely work for money. They can. But they don’t have to. At the farthest end of this spectrum you have families like the Rockefellers and the Rothschilds.
The second group are the people who, for the most part, come from a poor or middle-income household. But they are able to generate passive income because they understand the definition of what an “income” is and that it’s not exclusive to “working capital.” Or in other words, money that is derived solely from one’s work.
This group is where the majority of people can fit into. People like you and me. Where money wasn’t handed down to you, but you learn the concepts of money and put those principles to work in your life. Now that we’ve identified these two groups of people, let’s focus on this second group (the average Joes and the average Janes). How do people like this create passive income?
The answer is assets
What is an asset? An asset is something that you own, that produces income for you.
Your body, your energy are inherent assets. You’re born with it. But your own body has limitations. Physical limitations. So the amount of income you can produce with your own body and physical toil or effort is limited. This type of inherent asset is called “working capital.”
But as I’ve mentioned, there’s a limit to this type of capital/asset. So the type of assets you want to focus on are assets that you can acquire, to produce an income stream for you without you yourself expending any energy. Whether or not you’re there or not. Whether you’re awake or sleeping. An asset produces income for you. Going forward, when I reference the word “asset”, this is the type of asset I’ll be referring to.
Secondly, it’s important to identify that a thing that costs you money, like reoccurring expenses (i.e. monthly bills), are called liabilities. So they’re the opposite of an asset since they remove money from your pocket instead of putting money in your pocket.
So to summarize
#1. Human capital is limited so everyone needs to find other means of producing money passively.
#2. An asset is a thing that can make money for you.
#3. A liability is a thing that takes money away from you.
Now below, take a look at the diagram that shows the difference between people who stay poor and people who become rich.
In a nutshell, the poor, or middle class, make their income from their paycheck. Through work. But they use that money to buy things that take money away from them. They do not buy any assets. This group also includes the “upper middle class” that generate high levels of income, but do not convert any of it into a diversified basket of assets that produce a steady stream of passive income.
Even specialized surgeons that make upwards of $500,000 per year, I consider within this upper middle class group. If they spend 100% of what they make, and if relatively little is converted into assets. The reason being: they have to continue expending their own working/personal capital. They are not able to maintain their lifestyle without working and so nothing remains at the end of the day.
On the other side, the rich are those who use their paycheck to buy things like stocks, and properties that produces additional income for them. Over the long haul, the money derived from these multiple sources are then used to buy even more assets, which in turn produces even more income! And that’s how a stream of passive income is created. It’s a never ending cycle, and that’s how the rich are able to accumulate wealth.
And to contrast from the CEO or surgeon who makes $500,000 a year, but I still do not consider rich; even a janitor can become rich if he/she accumulates enough assets that produce a passive stream of income that equals or exceeds his/her expenses/consumption.
Here’s another image that similarly explains this concept:
This is one of the most important concepts I learned early on that completely changed my mindset on how I viewed money. I got these ideas from reading “Rich Dad Poor Dad” by Robert Kiyosaki and “The Richest Man in Babylon” by George Samuel Clason. I highly recommend everyone read both books (no, I’m not getting paid by either of them to promote their book – links are in my Recommended Reading list).
Build and maintain a stream of passive income
So going back to my original claim: “Building and maintaining a stream of passive income is the only way you can escape the rat race for good.” If you use 100% of the money that you make, then at the end of the day, you have $0 left over. So you’re forced to to make the same amount again and again and again and again. Just in order to continue living the same lifestyle. This is what keeps people in the rat race of life. There’s absolutely no way out of this scenario if you keep using 100% of the money that you make with zero left over to buy assets with.
To take it even further, a lot of people use more than 100% of the money that they make. How is that possible? With credit cards! In the past, it wasn’t this easy to get credit. If you didn’t have money, you couldn’t easily get a hold of more money. That was it. You couldn’t buy more “stuff.” But now, people are buying things on credit, even when they don’t have the money.
I highly implore you, if you’re one of these people (and chances are fairly high you are, at least to some degree, if you’re living in the US), then you should pay off your credit cards asap and live within your means. Don’t use money that you don’t have! It’ll only dig you further in the money pit and it’ll take you longer to climb back out and be at $0.
So with all that said, it should be easier to wrap your mind around what it would exactly take to get out of the rat race. You basically need to use less than 100% of your money. The less you use, on liabilities and consumables, the more money you can put towards assets that’ll produce income for you. And the more of these assets that you accumulate, the bigger your snowball gets over time. And once it gets big enough, it’s self-sustaining. You don’t need to add any more money to it unless you want to!
Here’s when you can exit the rat race
The point at which most people can exit the rat race is when the passive income derived from their assets can fully cover their expenses. And past this point, the decision to work more becomes a choice, and not a necessity. This is also referred to as financial freedom or financial independence. And as I’ve mentioned in my snowball article, the earlier you start in life, the faster you’ll get there; so don’t put it off. Start today. Anything is better than nothing, so don’t wait for an unknown date down the line, where you hope you’ll have more money to invest. You can typically start with as little as $100 if you want to put money in an index fund. And even less than that if you want to dabble in individual stocks.
Here are some broad categories of assets
Stocks/Equities (i.e. individual stocks, mutual funds, index funds, ETF’s, etc)
Bonds (i.e. intermediate and long-term treasury bonds, corporate bonds, etc)
Money Markets (i.e. treasury bills, certificate of deposits, etc)
Real estate (i.e. residential property, commercial property, REITS, etc)
Business (i.e. a small business, a hobby that generates income, etc)
Collectables (i.e. art, miscellaneous items like cards, comic books, etc)
My favorites out of these, that I find are truly “passive”, are stocks/equities, and bonds.
Real estate is another very popular method of building wealth, but does not provide a passive stream of income because acquiring and retaining tenants is not a passive endeavor. So it’s more like a business, or side job. My second favorite is business. You can do all sorts of things on the side to create additional income; and with that additional income you can grow your passive income snow ball even quicker.
Related: The Money Snowball Effect
Are you using spending 100% of your money on things that will never create additional money for you? What are some ways you’re going to implement these principles so that you can create a stream of passive income for yourself?