Passive Income vs Residual Income | Explaining the Difference between the two!
In the times where everyone is excited about enhancing their knowledge of personal finance, terms like passive income and residual income have gained significant traction.
Most people wrongly believe these terms mean the same but it is far from the truth.
In this blog, we'll delve into their definition and differences while understanding their role in personal finance.
Passive Income: A HandsOff Approach of Making Money
Passive income is the golden ticket for those seeking financial freedom without being tethered to a traditional 9to5 job. It involves earning money with minimal daytoday effort once the initial groundwork is laid. Picture it as a well oiled machine that, once set in motion, requires little intervention.
Examples of Passive Income include real estate investment, dividend stock, and more. You can find the ways of generating passive income here.
Residual Income: Beyond the Effort
Residual income refers to any money leftover. It is also commonly termed as disposable income which is the money that is left after paying off all the debts, additional obligations, and fixed expenses.
To understand the concept better, let’s take one example: if a person’s salary is Rs. 5,00,000 and he spends Rs. 3,00,000 every year on household bills, personal debts, groceries etc, then the remaining Rs. 2,00,000 is his residual income.
When it comes to residual income, there are 3 major types of it: Corporate finance, Personal finance, and Equity valuation.
- Corporate Finance Perspective: Within corporate finance, residual income refers to a company's net operating income or profits that surpass the stipulated rate of return. It serves as a crucial metric to gauge the financial health and success of a business.
- Personal Finance Context: In the realm of personal finance, residual income refers to any funds remaining after an individual fulfills all financial obligations, such as settling debts and covering monthly bills. This surplus income offers a measure of financial flexibility and the potential for wealth accumulation.
- Equity Valuation Framework: In equity valuation, residual income assumes the role of a financial model employed by investors to forecast the future value of stocks. This model takes into account a company's performance and residual income, providing insights into the anticipated trajectory of stock value based on its financial standing.
What is the difference between passive income and residual income?
Passive income and residual income, though sharing certain similarities, exhibit distinctive characteristics. While all residual income can be considered passive, the converse is not always true. Below, we highlight seven key distinctions between passive income and residual income:
Passive Income: Typically emanates from diverse sources such as rental properties, demanding minimal ongoing effort after the initial setup.
Residual Income: There are several different Residual income sources but in general, it comes from the industry a person works in. For example a chartered accountant might create an online course to sell and this can generate a residual income for him.
2. Purpose: Passive vs Residual Income
Passive income and residual income serve the same purpose of boosting the financial security of an individual, financial independence, and creating emergency funds. Businesses on the other hand can use this passive and residual income to enhance earnings for individuals, businesses, or investors, contributing to increased profits, dividends, and rewards.
Passive Income: Passive income typically involves an upfront investment of time, money, or specific skills, followed by minimal ongoing involvement.
Residual Income: On contrary to passive income, residual income may necessitate ongoing maintenance, such as updating content, as seen in the continuous efforts of a CPA maintaining an online course.
4. Risk: Residual vs Passive Income
Passive Income: Risks vary based on the income source, including tenant damages for property owners or financial risks for stock investors.
Residual Income: Generally entails minimal risks as it represents what remains after meeting financial obligations, often invested in passive income sources.
5. Viability: Passive income vs Residual income
Passive Income: It can be challenging for the average person due to substantial upfront investments, as seen in property ownership.
Residual Income: Tends to be more accessible, offering multiple avenues such as overtime work and debt reduction to generate additional income.
In conclusion, while both passive and residual income contribute to financial security and independence, their source, purpose, participation, risk, viability, and impact on financial security distinguish them in the realm of wealth creation.
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