Have you ever heard of the book “Rich Dad, Poor Dad” by Robert Kiyosaki? If not, the basic premise of the book is that the ‘Poor Dad’ (his dad) and the ‘Rich Dad’ both had respectable careers that paid well, but the financial situation of both was very different.
The ‘Poor Dad’ had a financial mentality that left him struggling throughout life, that differed from the ‘Rich Dad’s’ perspective which helped him to prosper. This difference in perspective was related to the spending choices made by both dads.
To summarise the book:
- The Poor Dad worked for money, the Rich Dad made his money work for him
- The Poor Dad acquired debt and liabilities, the Rich Dad acquired assets
- The Poor Dad believed he needed to earn more to be rich, the Rich Dad believed that it didn’t matter how much money you earned, it was about how much money you kept
In this context, I thought it would be a good opportunity to demonstrate how money can work for you if it is invested properly in assets.
Hopefully the practical application of this knowledge can help you become more financially aware.
How Can I Make My Money Work for Me?
You need to be able to find the right assets to invest your savings into. It is easy for many of us to just put our savings into a low yield savings account with our bank (some earning barely 0.1%).
If you are able to invest in an asset with an annual yield of 5%, then your return on that asset will be 50x greater than in the bank account I mentioned.
It is important to note from the start; building passive wealth and income is not an overnight job, and is not an easy feat.
You will need to knuckle down and build for your future.
Which Assets Can Make My Money Work?
I will go through some examples of assets that can provide a regular income stream each year.
You will need to determine whether the returns are worth the risks taken (because these are not guaranteed earnings).
You will also need to determine whether you are likely to need to liquidate the investment at any point, because some might come with liquidation costs (the fee to sell your holding).
Certificate of Deposit (CD)
I am going to start with the lowest risk asset that you can invest in if you are looking to build some passive income.
Certificates of Deposit are sold by local banks (under differing names, such as “Fixed Rate Saver”), and offer an annual return for a fixed amount invested over a defined period.
Traditionally, the rate earned from Certificates of Deposit were relatively high (around 5%), but the majority are likely to pay around 2% for the longest term CDs (a 3m CD will typically pay less interest than a 12m CD).
To earn £1,000 in passive income each year, you need to invest £50,000 in CDs at 2% AER/gross
The next product in the list which is a slight step up in risk is the humble Bond.
A bond is an instrument that allows the investor (you) to loan a fixed amount to a borrower (Sovereign, Corporate or other), with terms to pay back regular coupons on predetermined dates, and the full principal at the end of the period.
An example would be if you invest in a Bond with Apple which agrees to borrow £1,000 of your funds, for a 1.5% semi-annual coupon.
This means that you would get 1.5% of the principal (£1,000 * 1.5% = £15) every six months for the duration of the bond.
If it is a two year bond, you get 4 coupon payments, and then your full £1,000 back at maturity.
For two years, you would be paid £1,060 (principal plus four coupon payments of £15).
This would mean that the annual yield is around 3% (£30 per year).
Bonds are a fantastic way to diversify a portfolio (if you are aiming to build one), and some long term bonds (20 year duration) can even offer yields in excess of 5%!
To earn £1,000 in passive income each year, you need to invest £33,333 in Bonds at 3% AER/gross
If you own a stock or share in a private company, you are likely to be entitled to a dividend payout.
This is where the company has agreed to pay out a fixed amount as agreed by shareholders, to the shareholders.
This means that you can earn on your stock holdings, regardless of the current share price.
Dividends are usually paid as a way for a company to signal that everything is going well, and they want to share some of the profits with the shareholders that have invested in them.
If a company reduces their dividend payout, it could be a sign that they need more money to finance their operations (could be seen negatively).
Conversely, an increase in dividends is unlikely, as the firm may not want to overcommit to a large outgoing that could put them at risk of having to reduce the dividend later.
This is why I believe dividends are quite a safe option to build passive income.
The steps I take to find stocks that have good dividend potential, is to first look at the historic dividends paid (you can find the ‘Dividend Aristocrat’ lists that do this for you).
Next you want to check the dividend yield. This is an indication of the percentage of the stock price that is paid as a dividend.
For example, a stock has a share price of £100.
They pay an annual dividend of £3. This means that their dividend yield is £3/£100 = 3%.
It’s not uncommon to find stocks paying 4%+, and you will even be able to find some with 10%+ dividend yield.
If you are not interested in investing in single shares, you can purchase shares in index funds or ETFs which are where groups of stocks are bunched together, and shares in this diversified portfolio are sold to investors.
Typical dividend rates would be around 2% depending on the index fund you select.
To earn £1,000 in passive income each year, you need to invest £20,000 in Dividend Paying Shares at 5% Dividend Yield.
Buy to Let
The next one I will list is a controversial one, because it means increasing the demand for a broken housing market.
If you are looking for a large potential return, then investing in property with the intention of renting it out later can be incredibly lucrative.
In order to calculate the rental yield you could earn on a property that you own fully (i.e. paid for outright), you need to estimate the income (monthly rent * 12), and divide it by the property value.
A £250,000 property earning £12,500 a year in income would give you a rental yield of 5%.
The calculation gets a little more complex when you factor in whether you have taken a mortgage on the property.
If you take £200,000 mortgage (at 80% LTV, a £50,000 deposit), that costs £8,500 a year, then you’ll earn £4,000 a year.
Your investment was the £50,000 deposit, plus stamp duty (£10,000), and additional fees of £2,000, coming to a total of £62,000.
The rental yield is therefore £4,000 divided by £62,000, to give 6.5%.
Of course, the principal will be slowly paid for the life of the mortgage as costs are covered by the rent.
This means that the property yield should slowly reduce, unless you re-mortgage and put more deposits on other properties.
If you decide to manage the properties yourself, you will not have to pay administration fees for management companies, but will have to set aside costs for electricians, plumbers, repairs and more.
But for this to be truly passive, it is worth leaving the properties in the care of management companies that can cover the day to day running of the property, for a percentage of the rental income.
To earn £1,000 in ‘passive’ income each year, you need to invest £18,181 in Rental Properties at 5.5% Rental Yield.
Peer-to-Peer Lending (P2P)
Creeping further up in the riskiness scale, we arrive at Peer-to-Peer Lending.
The aim of peer-to-peer lending is to provide funds to willing borrowers, where they would otherwise have been turned down from traditional means (bank loans, or other).
Some crowdfunding platforms will automatically invest the funds you deposit into loans issued to borrowers, but others will allow you to selectively pick the borrowers that match your preferences.
The borrower doesn’t have to accept the rate you request, so you will have to bid for these investments.
You should also be aware that the borrowers on these platforms are likely taking a second chance at getting a loan that was rejected by banks.
This means that banks could see them as too risky, and is a factor that you need to understand when investing. The high interest rate is there for a reason!
It is common for investors to earn 7.5% annually on these investments.
To earn £1,000 in ‘passive’ income each year, you need to invest £13,333 in Peer to Peer Lending at a 7.5% Lending Rate.
There are multiple ways to start building passive income, and wealth, and this list is not going to be exhaustive.
It offers you a guide into the most common methods that ‘Rich Dads’ are using to make their money work for them.
Use the approach taken here, and you will be able to build a more secure future for you and your family.