Loan Basics Passive Income vs. Residual Income: What’s the Difference? – Investopedia

Passive Income vs. Residual Income: An Overview

Income refers to money a person or business entity receives to provide a service or when making an investment. Passive income and residual income are two categories of income. Although these terms are often used interchangeably, they are fundamentally different. While residual income may be passive, passive income isn’t always residual.

Passive income is money earned from an enterprise that has little or no ongoing effort involved. Residual income is not exactly a type of income but a calculation determining how much discretionary money an individual or entity can spend after paying their bills and meeting their financial obligations.

Key Takeaways

  • Passive income is money earned from an enterprise with little or no ongoing effort involved, but most likely, the upfront investment of a passive income stream took time and money.
  • Residual income is a calculation that determines how much discretionary money is available after financial obligations have been met.
  • Active and passive income streams are both taxed but in different ways.
  • Passive income can be earned in various ways, such as renting out your home on a home-sharing app or selling your crafts online.
  • Residual or left-over funds from active income can be used to support a passive income earning endeavor.

Passive Income

Passive income is earned with little or no effort, and individuals and companies often make it regularly, such as an investment or peer-to-peer (P2P) lending. The Internal Revenue Service (IRS) distinguishes it from earned income as money earned from an entity with which you have no direct involvement.

If an individual’s passive income is big enough, it can free up their time to do other things besides work. And although it may be risky when establishing the mechanism for passive income, it also offers increasing levels of financial security. If it provides steady cash flow, passive income can provide significant security because it’s not connected to your time. If it’s not enough to quit your day job, it’s still nice to have an additional income source to supplement what you earn from working. You may even have a better quality of life by moving more of your annual income to a passive source, especially if you have a lot of debt or a dependent gets sick.

Earned income is anything you work for, such as wages, salaries, tips, commissions, and bonuses. With passive income, you may be an investor or silent partner, but you are not the person heading up the enterprise.

One example of passive income is the profit realized from a rental property owned by investors who are not actively involved in managing it. Another example is a dividend-producing stock that pays an annual percentage. While an investor must purchase the stock to realize the passive income, no other effort is required.

Residual Income

Residual income is a form of passive income because entities may earn it without any effort. But it may mean different things depending on the context, whether that’s in the world of personal finance, corporate finance, or equity valuation.

Here’s a brief look at how each area looks at this kind of income.

Personal Finance

Residual income is the income an individual has left after all personal debts and expenses are paid in personal finance. Residual income is the level used to help figure out the creditworthiness of a potential borrower.

For instance, banks use residual income to determine whether applicants can afford a mortgage, comparing it to the cost of living in a particular area. To calculate residual income, the bank subtracts the mortgage payment, property insurance, and taxes, along with any other monthly payments—credit cards, installment accounts, or student loans from the applicant’s monthly income. The amount left—which doesn’t include food and utilities—is considered residual income.

Residual income can be passive, but passive income isn’t always residual. For example, mortgage lenders look at an individual’s residual income to decide how much money a potential borrower can afford.

Corporate Finance

Residual income in corporate finance is also referred to as a company’s net operating income or profit exceeding its required rate of return. It is any profit remaining after a company pays all its capital costs. A company’s residual income is generally used in assessing capital investment or business unit performance,

Equity Valuation

When it comes to equity valuation, residual income is an economic earnings stream and the valuation method used to estimate a stock’s value. The residual income valuation model values a company as the sum of book value and the present value of expected future residual income. This figure is calculated by subtracting the cost of net capital from net income.

When used in the valuation of investments, residual income is the net income generated more than the minimum rate of return. 

Special Considerations

Sometimes passive income and residual income are referred to as the same thing, the money you earn with little to no effort. But they are not interchangeable because they can mean very different things. For example, if you own a small business, your residual income is calculated by the profit made after you pay all of your bills. As an individual, residual income is how much you have leftover after you pay your debts and financial obligations like a mortgage, or rent, and your debts.

When you define residual or passive income in terms of earning money on a regular basis due to stocks, royalties, or rental income, it is easy to see how the two terms are similarly descriptive. Passive income versus residual income and how they are defined depends on the circumstances of an individual or company.

Passive and Residual Income FAQs

How Can I Create Residual Income?

There are relatively easy ways to create residual income. Renting out a room or your whole house on the weekends, tap into your hobbies, like selling your photographs or crafts online, or consider learning about stocks and peer-to-peer lending opportunities.

What Is Active Income?

Your job earns active income in the form of a salary, hourly wage, tips, and commissions. Active income means you are performing tasks related to your job or career and getting paid for it. Active income takes up your time. Passive income allows you to earn money with minimal effort.

How are Passive Income and Residual Income Taxed?

Passive and residual income is taxable but not at the same rates as active income, and the amount you owe depends on numerous factors, like if the income is from financial dealings or real estate.

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