We know that it’s important to have multiple sources of income, especially ways to earn money passively. Creating multiple income sources gives financial security, diversity and better earnings potential. One such income source is passive interest income. In this post we’ll take a look at what interest income is and how interest works. We’ll also look at some ways to make passive interest income to boost your earnings.
See the reasons why passive income is important.
What are the pros and cons of active vs passive income
Table of Contents
What Is Interest?
Interest is money earned in return from lending money to others. It works two ways – if you are a borrower, it is the charge you pay for borrowing that money. If you are a lender, it is the money you earn in return for lending money out.
One of the simplest examples of interest in action is depositing cash with your bank. You are actually lending your money to the bank which is why they pay you an interest rate in return. The bank in turn uses this money to fund other activities such as loans and mortgages, charging those borrowers interest. The difference in this cost is the net interest margin and is the bank’s profit.
If you have spare cash available you could be putting this to work earning you passive interest income to boost your earnings. Before we review the passive interest income options available it’s important to note there are different types of interest. Simple interest and compound interest. We’ll explain the difference below with examples of these 2 types of interest.
Types Of Interest: Simple Vs Compound
Simple Interest
Simple interest is only applied to the principal capital. It does not compound. Common assets using simple interest are loans and bonds.
It is quite simple to calculate total returns using the following formula;
Simple interest = P (1+IT)
Where;
P = Principal amount
I = Annual interest rate
T = Time (in years)
Simple Interest Example
As an example, you invest $10,000 paying a 10% interest rate to be repaid annually for a total term of 5 years. You can calculate the total interest payment you would receive after the 5 year term using the above formula.
Where;
P = 10,000,
I = 0.1 (percentages expressed as a decimal)
T = 5
So the formula would look like 10,000(1+0.1×5) which when calculated gives a total of $15,000. This means at the end of the 5 year term of your investment you would have earned a total of $5,000 in interest income.
Compound Interest
Compound interest is applied to both the principal amount and the interest accrued. The accumulation of interest on interest provides a snowball effect where the overall returns will grow significantly if left for a long period of time.
Compound interest can be more complex to work out as there are a number of variables that can effect it. This includes the schedule of interest payments I.e. daily, monthly, annually etc.
Calculate total returns from compound interest with the following formula;
Compound interest = P (1 + r/n)^(nt)
Where;
P = Principal amount
r = Interest rate
n = Number of times interest applied per time period
t = Number of time periods elapsed
Compound Interest Example
Let’s use the same figures as in the simple interest example above to see how much would be accumulated if compound interest was applied.
So a $10,000 investment, receiving a 10% interest rate applied annually for a total period of 5 years.
Input these figures into the formula as so;
P = $10,000
r = 0.1 (Percentage expressed as a decimal; 10/100 =0.1)
n = 1 (interest paid once per year)
t = 5 (total of 5 years)
So it will look like; 10,000 (1 + 0.1/1)^1×5 = $16,105.10.
This means at the end of the 5 year term you would have earned $6,105.10 in compound interest income. That’s $1,105.10 more than you would earn had it only paid simple interest.
This demonstrates the power of compounding. The longer you leave something to compound the larger it will grow over time. It is one of the biggest drivers of wealth and is why compounding is an essential financial element to understand.
It is not only interest bearing assets, compounding is applicable to dividend investing as well, with dividends earned on dividends. Compounding passive interest income can make you very wealthy.
Albert Einstein quoted compounding best;
Compound interestis the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Albert Einstein
Ways To Earn Passive Interest Income
There are several ways to earn passive interest income and boost your earnings. Earnings are usually proportional to the risk level.
For instance cash is the most secure option but generally pays a lower amount of interest. Whereas investment assets such as bonds carry a little more risk than cash and so usually pay higher rates of interest. Although these in turn are usually less volatile than stock market investments and can provide a more stable return.
It is a good idea to spread your money across different types of assets to minimise risk and maximise returns.
High Yield Savings Accounts
High yield accounts are a type of savings accounts that pay higher rates of interest than standard savings accounts. The accounts paying the highest interest rates tend to be operated by digital banks. As their operating costs are lower than for traditional bricks and mortar banks, they can pass these savings onto consumers.
View the best online savings accounts interest rates.
Certificate Of Deposit (CD) Accounts
A certificate of deposit account, or CD, is a type of fixed term savings account available at pretty much any bank. As they are fixed term savings products you are not able to access your cash early, doing so may incur penalty fees. In return for locking away your cash, the interest rates offered are usually much higher than other types of accounts.
Interest Paying Checking Accounts
Many banks offer checking accounts that pay interest on your balance. These may be referred to as reward checking accounts.
The benefit of these is that you can earn interest from any money in your account without having to deposit it into a savings account. Interest rates can also be higher than on some savings accounts.
However, unlike savings accounts, there are likely to be more restrictions. For instance, you usually need to maintain a high minimum balance. Or carrying out a certain number of monthly transactions to qualify for interest.
There are some banks like Axos that offer up to 1.25% APY on their Rewards Checking account with no minimum balance and no monthly service fees.
Money Market Accounts
A money market account is an alternative cash savings product offered by banks. Not to be confused with money market funds, which are also a type of passive interest income security.
It is a kind of hybrid account combining elements of both a savings and checking account. They usually have higher rates of interest than standard savings accounts along with debit cards and check writing.
But this often comes with restrictions such as maintaining a high minimum balance. If you do not meet the minimum requirements then fees may apply.
The average interest rate is only 0.08% APY but there are banks like Quontic offering many multiples of the average at up to 0.60% APY with no monthly fees and just $100 opening balance.
Corporate Bonds
Bonds are a type of fixed income investment that work like a loan. When you purchase a bond, you are lending money to the bond issuer who pays you back with interest. Income is fixed in that the borrower pays back on a regular schedule over the course of the bond term until it is fully repaid at maturity.
Corporate bonds are those issued by corporations to raise cash to fund their new projects and business activities. Interest rates on bonds varies by a number of factors including the company’s credit rating.
The higher the rating, the more likely the issuer is to pay which generally keeps interest rates lower. The lower the credit rating, the less likely the issuer is to repay. This can produce high yields. The lowest rated of these are ‘junk bonds’ and have high yields but high chance of default.
It is possible to invest in individual bonds or in a bond mutual fund. Mutual funds are a good option for diversifying a bond portfolio and providing regular income.
Trade mutual funds commission free with apps like Public.
Government Bonds
Governments can also issue bonds with the money raised going towards infrastructure investment, deficit management and controlling monetary supply. They are usually lower risk than many corporate bonds as they are backed by a government. As such they will pay lower rates of interest.
However government bonds do still present some risk, especially those in emerging markets. These are more likely to be effected by political and financial risks. Whereas US government bonds are among the safest and lowest risk in the world.
Local governments may also issue bonds for local infrastructure projects, known as municipal bonds.
Mutual funds and ETFs can be a great way to invest in various types of bonds. Funds give instant diversification by spreading risk across many bond holdings. This also ensures a more steady and reliable regular stream of passive interest income. Re-invest income back into the fund to purchase more units which will in turn generate more interest income. This is the compounding effect.
Money Market Fund
A money market fund should not be confused with a money market account. Money market funds are a type of mutual fund that invest in short-term, highly liquid securities. This includes cash, cash equivalent securities and short term debt securities.
Some of the financial instruments money market funds may invest in include commercial paper, certificates of deposit and repurchase agreements. Although they do carry an element of risk, money market funds are generally considered low risk.
They are unsuitable for long term investing. This is because they offer little capital gains and are based around short term income. This makes them good to hold in the short term instead of cash such as when temporarily holding cash before making an investment.
Whilst a money market fund works in much the same way as other mutual funds there is one notable difference. A money market fund aims to maintain it’s net asset value at $1 per share. Any gains above $1 are usually distributed to shareholders as dividends. This results in a regular income stream and makes them popular with investors looking for income.
P2P Lending
Peer-to-peer (P2P) lending is a type of fixed income debt instrument that works similar to bonds. P2P loans allow individual investors to loan money directly to other individuals and businesses through an online platform. Borrowers pay back the loan with interest at a regular fixed schedule.
P2P Lending apps like Lenme make it easy to invest in P2P loans, using an algorithm to match you to the most profitable returns.
Passive Interest Income Conclusion
Interest is money earned in return for lending money to another. The two main types of interest are simple and compound. Simple interest only applies the interest to the principal amount. Whereas compound interest applies the interest to both the principal amount and the interest.
Compound interest is most beneficial for investors and those looking to grow wealth over time. It allows for the accumulation of interest on interest.
Even those assets paying simple passive interest income such as bonds can be made to compound. Simply re-investing income back into that same asset will achieve this. By holding more of that asset, you receive greater income in future.
There are several ways to earn interest income and start to make money passively. These include several different types of savings accounts, corporate and government bonds and peer-to-peer loans.
Passive interest income is only one type of income source but there are many more you should be acquiring. Read our post to learn why it’s important to have multiple sources of income.
Find more essential reading on our blog including the following;
- What is SaveBetter savings marketplace?
- Financial lessons everybody needs to master.
- 10 investment ideas to build wealth.
- What are the different types of dividends?
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