How Much Passive Income Do You Need?

Most people I speak to, when they want to measure someone’s wealth, measure wealth by referring to how many houses they have. For example, “John owns 14 houses. He is rich.” However, someone may own 14 houses, but each house may only be worth $200k, which gives total assets of $2.8 million. However, what if he also had $2.7 million worth of debt? His net worth would be $100k whereas someone who owns one house worth $1 million that is fully paid off would be 10 times wealthier even though he owns 14 times fewer houses. This example clearly demonstrates how misleading a count of houses is. A more sensible approach is to calculate net worth.

However, net worth can be misleading as well. For example, suppose you inherited a house from your parents that was worth $500k and you live in this house. Suppose suddenly this house went up in value to $1 million. Are you better off? Your net worth has increased by $500k, but because the extra wealth is within the house, you cannot unlock it unless you sell the house. If you sell the house, you’d still need a place to live, so you’d buy another place. The problem is that if you buy another place, that home will have risen in value as well, so the net effect is that you have paid taxes, real estate agent fees, conveyancing fees, etc but there is no difference in your living standards. You are worse off. If you downsize and buy a cheaper place, you’d be able to unlock your extra wealth, but then your living standards drop (e.g. extra commute time).

This point highlights that net worth, although better than a count of houses, has its flaws. An alternative metric, in my opinion, is passive income. Passive income (e.g. from dividend income but also from rent, interest, etc) is income you receive by not working. Passive income should subtract any debt as debt is negative passive income. Debt is the opposite of passive income because you must work to pay off debt. This applies if you hold debt as a liability. If you hold debt as an asset (e.g. you own bonds) then this is passive income. The bonds generate interest for you that you can live off without any work.

Passive income is more useful because it directly measures your standard of living. If your net worth goes up by $500k, that may have zero impact on your standard of living. However, if your passive income goes up by e.g. $1000 per month, that is actual cash in your hands. It directly impacts how much you spend and directly impacts your standard of living.

So how much passive income is enough? It all depends on the person. Everyone is different. It also depends on the city you live in. Some cities are expensive while others are cheap.

However, using Melbourne, Australia for this example, in my opinion, to cover the basic necessities of life, passive income of about A$2000 per month (US$1500 per month) at a minimum is needed, in my opinion.

Currently I work, and I do like my job at the moment, but loving my job is a recent experience. For a long time I have hated my job mainly because I have had bad managers. Something I have learned is that things change all the time at work, so you need to have an exit plan at all times. Too many people get a job, expect they will always love the job and always make good money, so they go into debt to get a mortage, have children, inflate their lifestyle, etc and then suddenly they find they hate their job, but by then they are trapped. I made this realization early on in my career because, when I started working, I went through a restructure in the organisation. I learned quickly how risky it was to have debt and obligations, and I realised the value of structuring your life so that you have the ability to walk away from anything, not just your job but from any person or any organisation. There is great power in being able to disappear at the drop of a hat, and this is achieved with passive income coupled with minimum or no obligation (including financial obligation i.e. debt).

Don’t let yourself get attached to anything you are not willing to walk out on in 30 seconds flat if you feel the heat around the corner.

~ Neil McCauley

Even if there were a restructure at work or a tyrannical manager took over and started legally abusing staff, with passive income of $2000 per month, it is easy to stop work and live an urban hermit lifestyle e.g. renting a one-bedroom unit on the outskirts of the city (e.g. this place in Frankston), living off Aussielent, and surfing the internet all day. The only costs are rent ($1000 per month), Aussielent ($320 per month), wifi ($50 per month), electricity ($100 per month), and water ($100 per month), which comes to a total of $1570 per month. I round that up to $2k per month just to give a little buffer. Nevertheless, this is quite a spartan minimalist lifestyle. Doubling it makes $4k per month passive income, which I feel is enough to really enjoy a comfortable and luxurious lifestyle e.g. travelling, living in the city, eating out, etc. Nevertheless, $2000 to $4000 per month in passive income is a good range to aim for.

Buy Banks, not Houses #Budget2017

Buy bank ETFs and rent a cheap unit instead.

Recently the Australian government has announced in its Budget 2017 that there will be a bank tax applied to the five biggest banks in Australia. This may affect me because I live off dividends, and much of these dividends come from Australian banks via ETFs. When I mentioned my concerns to others, I was surprised at how much hatred others have for banks in Australia, which is surprising to me.

I am not too concerned by the bank tax, and I will continue to invest in ETFs that invest in high-dividend paying stocks (e.g. HVST) as well as the finance and banking sector (e.g. OZF and MVB).  The reason why I am confident is because I feel that banks can simply pass on the tax expense to borrowers by raising interest rates and fees. Many people may be unhappy about this, but they have the freedom to take their business to other banks.

Banks should also benefit from the cutting of the corporate tax rate from 30% to 25%.

The housing affordability scam

The budget also includes a complex scheme whereby people saving up for a deposit to buy a home can salary sacrifice at most $30k per year into their superannuation fund thereby obtaining tax benefits and then taking that money out to use as a deposit on a home.

This, in my opinion, is such a scam because it is effectively the same as the various grants that the government gave to home buyers. Why put first home buyers through the whole process of putting money into super to get tax benefits and then taking it back out again? Why not just give the expected tax savings to these first home buyers directly?

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The scheme also does nothing to address housing affordability because every economist knows that the price of housing will go down if demand goes down and supply goes up. If there are tax benefits to using super, and if super is used to buy houses, this will only increase demand, which increases prices. Make no mistake, this scheme does not help buyers. It is designed to prop up the market.

Once again, first home buyers are being scammed. The major problem is that most first home buyers don’t understand economics and believe that the government giving them money will help them buy a house. Rather, it will simply drive house prices up even more thereby requiring them to get into even larger debt. The debt that they’d be getting themselves into will also be nondeductible debt, which means they pay more tax than if they had borrowed the money to buy a investment property or other investment e.g. ETFs.

What should you do?

Unfortunately I don’t see the housing affordability issue being addressed because too many people benefit from high house prices, so governments will do what they can to prop up the market. Homeowners benefit from higher prices; banks earn interest from mortgages; and real estate agents, property developers, builders, and lawyers also make money from the property boom. Those hoping to buy a house suffer, but the solution seems to be to help them become homeowners, and when these young homeowners finally buy a house with government support, they have a vested interest in high property prices, but what many of them don’t seem to understand is that they are buying into a very expensive market by loading themselves up with so much debt they effectively become slaves to the bank.

Those who borrow from banks to buy houses believe they are oppressing renters, but really in most cases it is the other way around. Rental yields are so low that the average Melbourne house only produces about 3% in rental yield. If you had $1 million and invested it in a house and rented it out, you make $30k in rent. Had you invested that money in NAB shares as of today you’d be earning 8% dividend yield, i.e. $80k per year if you invested $1 million, which means you could invest your $1 million in bank stocks, earn $80k, rent that house you wanted for $30k, and have $50k leftover. By buying the house, you lose $50k in opportunity cost.

The market will continue to be propped up because everyone benefits, and those who don’t benefit think they are benefitting. First home buyers think that by receiving government money they are closer to buying a home, but they don’t realize that homes will be more expensive. Those who recently bought a home think they are better off than if they rented, but they don’t understand how much they will pay in interest nor will they understand how much opportunity cost there is in owning property. The best slaves are those who believe that they are the oppressors.

The major problem with housing is that it is commonly associated with a debt-fuelled depraved and wasteful materialistic lifestyle. Once someone borrows large sums from the bank, it is not just a massive house that they buy. They increase their spending in other ways, e.g. furniture and renovations. The debt that they hold tricks them into believing that they have more than they actually have.

The solution then is to go back to basics. Own bank ETFs and live cheaply off the dividends. You can rent a cheap self-contained unit in the outer suburbs for less than $250 per week and then wake up early to commute to work via train. Insecure tenancy is not a problem in the age of Airbnb. Renting gives you the freedom to move to different areas to minimize costs and maximize opportunities. Renting also frees up cash flow to enable you to seek out the best investments.