Difference Between Passive and Residual Income
The idea of making money without doing an active job sounds pretty sweet. When people talk about “making money while you sleep” (although this is a myth ), they usually mean passive or residual income. While the two terms are often used interchangeably, there are some key differences between the two. Here’s what you need to know about the differences between passive and residual income and what they mean for you when you get extra money.
What is passive income?
Theoretically, passive income sounds like this: money that you earn without doing active labor at a regular day job. This income starts to come in after you have invested a certain amount of time or money up front, with minimal ongoing effort beyond your initial investment.
Examples of passive income include renting a spare room through a shared living app or selling clothes online. On the other hand, most things that are considered passive income (real estate, book royalties, online sales, etc.) require a lot more work and consistent effort than financial gurus would let you know.
What is residual income?
According to Investopedia , there are three main definitions of what residual income means in various contexts (personal finance, corporate finance, or capital appreciation). In terms of personal finance, our main concern here is residual income, which is any residual income that someone has left after they have paid off all their debts and bills. If you apply for a loan, your residual income is used to determine your creditworthiness as a borrower. Essentially, this is another term for discretionary income.
This definition means that residual income is often passive; this does not mean that passive income is necessarily residual. In fact, the remaining money from your main source of income can be used to support a new passion for passive income. Both passive and residual income are taxed, though not at the same rates as active income.
bottom line
While both residual and passive income can increase your financial security, passive income will have a greater impact, as explained by Indeed.com . Think of it this way: Let’s say you pay all your bills and reduce your debt by $500 a month, thus creating a residual income of $500. If you were also renting out the vacation home in the same month, you could earn over $1,000 in passive income – clearly a bigger win. The caveat here, of course, is how you define “passivity” when it comes to booking and maintaining this rental property.
Ultimately, when people talk about extra cash flow with minimal effort, they are talking about passive income, not residual income. You may need residual income to start a “side job,” and then that passive income can add to your total residual income—all the money left over after your bills have been paid.