Passive Income vs. Residual Income: An Overview

Passive income is money that is earned from an enterprise that has little or no ongoing effort involved. Residual income is not actually a type of income, but rather a calculation that determines how much discretionary money an individual or entity has available to spend after financial obligations or bills are paid.

Passive Income

One example of passive income is the profit realized from a rental property that is owned by investors who are not actively involved in managing the property. 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.

The attraction of establishing some sort of method for earning passive income is that it frees someone up to do other things with their time besides work...if the passive income is big enough.

Passive income also offers increasing levels of financial security. Although you might take a risk when first establishing the mechanism for passive income, if it proves to be a steady flow, it offers great 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 source of income to supplement what you make from working.

Especially if you have debt or student loans or kids or a spouse that gets sick, the more you can get your annual income switched to passive, the better quality of life you'll have.

Residual Income

Residual income is the amount of net income generated in excess of the minimum rate of return. Alternatively, in personal finance, residual income is the level of income that an individual has after the deduction of all personal debts and expenses have been paid.

Residual income is also a number that banks calculate when determining whether applicants can afford a mortgage. To calculate residual income, the bank determines the applicant's income and then subtracts the anticipated mortgage, property insurance and taxes. Any monthly payments made to credit cards, installment accounts or student loans also are subtracted from income. Food and utility expenses are not included in the calculation. The amount that is left after the subtractions are performed is considered residual income.

Banks compare an applicant's residual income to the cost of living in a particular area to determine if the individual's budget is too tight to handle a mortgage. For instance, an applicant who lives in the South and has a family of four must have a residual income of at least $1,003 a month if he wishes to take out a loan backed by the Veteran's Administration.

In equity valuation, residual income is an economic earnings stream and valuation method for estimating the value of a stock. The residual income valuation model values a company as the sum of book value and the present value of expected future residual income. 

Key Takeaways

  • Passive income is money that is earned from an enterprise that has little or no ongoing effort involved.
  • Residual income is not actually a type of income, but rather a calculation that determines how much discretionary money is available after financial obligations have been met.