Stocks or private lending? Which is better to make passive income?
The idea is to plug a lump sum of cash into an investment and reap regular cash returns.
You can do this with both stocks and private lending, but are both equally suited to make passive income?
Let’s look at how much work is actually required to make passive income with both stocks and private lending. But we’ll also look at the ugly side of both stocks and private lending. You need to know what you’re putting your money into.
No more preamble though. Let’s dive in…
How to make passive income with private lending
If you have cash in a TFSA, RRSP, or if you can cash out equity from your home, then it might be worth it to find a mortgage broker you trust and lend out your cash in private mortgages.
There are two important elements to any private mortgage:
- A mortgage broker you trust with your hard earned money
- A borrower that has an unbeaten track record of paying back loans
With those two elements in place, your mortgage broker will help with the technical process of lending your funds. They bring in their trusted lawyers to write up the contracts.
The beautiful thing about being the lender in private mortgages is that the borrower pays all legal fees.
You make money in two ways with private mortgages:
- Upfront lender’s fee
- Interest payments on the loan
The lender’s fee is usually 1% – 3% of the loan value that the borrower pays up front (although it’s lumped into the loan, so you don’t actually see that cash right away).
The interest payments are deposited into your account each month for the duration of the private loan (which can range anywhere from 3 months to 3 years).
As long as the borrower doesn’t default on the loan, you have a steady stream of income until it’s fully paid off.
The ugly side of private lending
Your private loan can fail at two points: the mortgage broker and / or the borrower.
We have close family friends who had one loan go bad on both the borrower and mortgage broker’s end. They’re income stopped dead and their mortgage broker wasn’t talking to them. Scary stuff.
You’d think that investing with bigger corporations, like developers, would provide more safety. Unfortunately that’s not always the case.
Fortress Real Developments in Barrie, ON
We had one client invest with a big developer in Barrie, ON, Mady Development. The developer went bankrupt before finishing the project and sold it to Fortress. Our client was one of the 949 investors in Barrie who lost all of their invested money when Fortress also collapsed in 2018.
Epic Alliance in Saskatoon, SK
A more recent example of private lending’s ugly side is Epic Alliance. They took more than $10 Million in unsecured loans from private investors all over Canada, then defaulted on those loans. Investors lost everything, or found themselves owning run-down rental properties that were several provinces away.
What happens when a private loan goes sideways
First, there can be lengthy legal proceedings. So you’re not seeing any cash payments until the court resolves everything. You’re also on the hook for lawyer’s fees then.
Second, you probably aren’t the only lender that the borrower owes money to. And there is an order to which creditors get paid out. You can be down a very long list of creditors that get paid out before you do. There may not be much, if any funds left by then.
Third, you could end up owning a property you never wanted to manage. This is especially difficult if the property isn’t close to home. All of the sudden a passive investment becomes an active investment that you weren’t prepared for.
This is why it’s extremely important to find a mortgage broker with a spotless reputation and a borrower with a crystal clear record.
Even then, history proves that your money is safer in your hand.
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How to make passive income with stocks
There are two primary ways to make passive income with stocks:
- Dividend stocks
- Stock options
The beautiful thing is that you can stack a dividend investing strategy with stock options to boost your monthly income.
Passive income with dividend stocks
Dividends are cash payments companies make to shareholders. Usually these payments are made quarterly, but some companies pay monthly dividends.
NOTE: This is not a recommendation. This image is meant only for educational purposes.
Not all companies pay dividends, but the ones who do will have a “Dividend Yield.” This is the annual return of the dividend payment per share vs. the price per share. It’s your ROI.
So in the example above, TD has a dividend yield of 3.8% annually. That means that you get paid 3.8% annually in cash for every share of TD you hold.
That may not seem like an awesome return, but remember, that’s on top of the stock price appreciation. In the image above, TD’s price appreciated 53% in 5 years. That’s 10.6% return in the last 5 years. Plus the dividend, that’s a 14.4% return each year (assuming the dividend yield was constant, which isn’t guaranteed).
Average dividend yields range from 3% to 6%, but there are companies and funds that pay 7% – 10% annually as well.
Passive income with stock options
Strictly speaking, trading stock options isn’t passive. But you don’t have to be a day trader to find cash flow either. In fact, we’ve learned how to trade stock options (or “stock hack” as we call it) in a way that’s low input and low stress.
We cover the basics of stock hacking in our Options for beginners series. But here is the snapshot of how this could work. If this intrigues you at all, make sure you read through Options for Beginners to learn more about how stock options work.
One way to make money with stock options
Options are contracts of 100 shares of a company. These contracts are traded on the market just like stocks.
There are many ways to make money stock hacking, but here’s the simplest we know of (and you can do this in your registered accounts.)
Let’s say you own at least 100 shares of TD (again, not a recommendation, just using TD as an example).
You originally bought TD at $40 per share. You wouldn’t mind selling those shares for $60 a piece. So you write a contract (in this case, it’s known as a “call”) that promises to sell 100 shares for $60 a piece if TD’s stock reaches that price in 30 days.
Someone wants the right to buy those shares from you, so they pay you a small premium up front to set those shares aside for them, in case they reach $60 in the next 30 days. Maybe they believe TD will continue to rise after that.
They pay you a premium of $0.25 per share. Since the contract is for 100 shares, that’s $25 up front deposited into your account. (NOTE: Option premiums fluctuate a lot, so this is purely hypothetical.)
Two things can happen now:
- If TD is worth $60 or more in 30 days, your shares are called away. You collect $60 per share and keep the $25 premium.
- If TD is worth less than $60 in 30 days, you keep your shares and the $25 premium. Then you can write another contract and collect more premiums.
So not only are you collecting dividends from TD, you’re also collecting option premiums and benefiting from any stock price appreciation.
If this tweaks something in you, read through Options for Beginners to learn more.
The ugly side of stocks
The stock market crashes sometimes. That can be really scary.
Companies go out of business and their stock goes to $0.
Individual stocks get stuck in a rut, seeing little to no appreciation for years at a time.
This is why it’s important to look for companies that have survived crashes and business slumps many times before.
What you really want to find are “Dividend Aristocrats” who have increased their dividend payout every year for the last 25 years. This isn’t a guarantee of success, but it’s can indicate that a company knows how to weather tough times.
Take TD for example:
After many slump, drops, crashes and even a recession, it’s still up over 1,400%. But remember, this is a 20+ year view. So if you can keep the long game in mind, history is on your side.
Another big advantage stocks hold is that they are completely in your control.
If you see a company start to slide, you can get out quickly. Even if you take a loss, you have your capital back within a few days. That can’t be said of funds locked up in a private mortgage that’s gone sour.
Also, you don’t have to invest in one company. You can buy units of funds that follow the market as a whole. That way you’re not exposed to just one company, or even one sector.
What do I do with this information
This is just the beginning. Pick your preferred investment vehicle and start to educate yourself thoroughly.
Also, understand what you’re hoping for from your investments. Do you want to see a monthly pay cheque with no work involved?
And where do you feel most comfortable putting your life savings?
Answering these questions gets you started down the right path. If you’re keen to learn more, consider subscribing to our Stock Hacker Report. It’s a weekly email full of education much like this article. And if you subscribe right now, you get a free download of our latest report, “How Real Estate Investors Find Cash Flow in the Stock Market.”
That’s all for now.
Happy trading,
Your fellow Stock Hackers,
🍒Cherry & Erwin
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