Passive Income vs. Residual Income: An Overview
Income refers to money a person or business entity receives in exchange for providing a service or when making an investment. Two types of income are passive and residual 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 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 is money earned from an enterprise that has little or no ongoing effort involved.
- Residual income is a calculation that determines how much discretionary money is available after financial obligations have been met.
Passive income is earned with little or no effort, and it's often earned by individuals and companies on a regular basis like 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. Remember, earned income is anything you actually work for such as wages, salaries, tips, commissions, and bonuses. But with passive income, you may be an investor or silent partner—not the person heading up the enterprise.
If the passive income is big enough, it frees up a person's time to do other things besides work. And although it may be risky when first establishing the mechanism for passive income, it also offers increasing levels of financial security. If it provides steady cash 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. 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.
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 can be passive, but passive income isn't always residual.
Residual income is a form of passive income as 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.
Residual income is the level of income an individual has left after all personal debts and expenses are paid in personal finance. The level of income can be 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 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,
When it comes to equity valuation, residual income is an economic earnings stream and valuation method that is used to estimate 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. 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 amount of net income generated in excess of the minimum rate of return.