What is Residual Income?
Residual income for businesses is what’s generated above the minimum required return, but for your personal finances, it’s how much you have left over after paying all of your expenses.
🤔 Understanding residual income
The terms residual income and passive income are often used interchangeably. However, the terms can mean very different things depending on whether you’re referencing a business environment or talking about an individual’s finances. In the corporate world, residual income is a measure of profit after the company pays all costs of capital. Personal residual income is what you have left after you pay your expenses and debts. Lenders often look at your residual income when applying for a mortgage or a personal loan. However, passive income and residual income are similar, especially when talking about revenue that is being generated on an ongoing basis. Plenty of ways exist to create residual income. How you create and calculate residual income can vary depending on the environment or industry you’re working in.
Say Jim’s take-home pay is $4,000 a month. He has a monthly car payment of $500 and a monthly mortgage payment of $1,000. His residual income is calculated as follows:
Residual Income = Monthly Take-Home Pay – Debt Payments
So, in this case, that is:
Residual Income = $4,000 – ($500 + $1,000)
Therefore, Jim’s residual income is $2,500.
Residual income is the money left over after you pay your bills…
You calculate your household budget according to the regular paycheck that you earn from work. All of your income is budgeted and accounted for each month, and you spend the money on housing costs, groceries, utilities, entertainment, retirement savings, and other expenses. This amount is the minimum you need to earn to cover the cost of your living expenses. But one month you might pay less in utilities because you made sure to turn out the lights, or maybe you got a bonus check at work; now you have more money than you need to cover your bills. The cash you have from spending less or getting a bonus is above and beyond what your minimum required earnings are, so it’s residual income.
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What is residual income?
Residual income is often confused with passive income. Depending on the topic, the terms can be similar. In some situations, residual earnings differ greatly from what you earn passively. It depends on the context.
For instance, in a corporation residual income is a measure of the amount a company makes above the minimum amount they need to earn to stay in business. In that sense, residual income isn’t income at all. It’s more a calculation of money that is leftover after the business pays for the cost of operating, such as building space, employee wages, and cost of materials. You can also use residual income to determine how much a company is worth. This method relies on equity valuation to calculate residual income.
Most people make money according to the work they produce, which is active income. You go to work, and your employer issues you a paycheck for your time and output. But in some kinds of businesses you can make residual income as passive income — Income you earn while putting in very little or no effort to collect the money. Residual or passive earnings in this scenario is money you earn without having to work for it actively (after making an initial investment of time and/or money). Real estate investing, becoming a blogger and earning money from online ads on your archives, writing a book, or opening an online store are some residual income ideas you can generate online.
For your personal finances, residual income is the same as discretionary income. It’s a measure of the money you have left after your debts and fixed expenses are paid. Lenders often base a portion of the decision of whether to let you borrow money on how much residual income you have each month. If the amount is too low, the lender may think you don’t have enough cash to make the monthly payments.
What are the types of residual income?
Company value: If you want to know the intrinsic value of a company, you use equity valuation to calculate residual income. To find out the value of equity, investment banks determine how much the company’s stock is worth as part of the calculation. The analysts and associates that work at investment banks may do industry research, analyze historical financial results, and forecast future profits as part of the equity valuation process.
Corporate finance: Residual income in corporate finance is how they calculate profit. As a measure of how much a company profits after subtracting the opportunity costs of capital, it functions as a measure of internal performance. The internal performance calculation can influence how much compensation executives receive and whether they might get a performance-based bonus.
Online business: Setting up an online business can be a way to generate a residual income stream. In the online business world, residual income is the same as passive income. It measures the profits you earn after you put in the initial investment. You might open a storefront online to sell in-demand products or write a book to sell from a website you create. You will probably put in significant effort at the beginning to get the business and products up and running. There is typically very little work required to maintain the flow of income once everything is in place, which is why it’s called residual (or passive) income.
Personal finance: The amount of money you have leftover after you pay your bills and fixed expenses is your residual income. You might have heard of discretionary income, which is the same thing. It’s cash that you have the freedom to spend at your discretion.
What is the difference between residual and passive income?
When talking about passive and residual income, the terms can have the same meaning. But that isn’t always the case. Further complicating matters is the fact that passive income can generate residual income. While there are several similarities and differences between the two, the deciding factor depends on the industry you’re in.
Generally, residual income is the income you get after you’ve already put in the hard work to generate a profit, while passive income is automated. Operating a bookstore can generate residual income. You put in the work of buying books and setting up your store, and buyers arrive at your site without you having to set up a new storefront each time.
Earning a return on stocks and bonds is passive income. Once you buy the stock initially, the returns you earn are automated based on your investment.
In a corporate environment, residual income takes on a new meaning. Net profits take into consideration the operating expenses of a business. Residual income goes one step further to measure company profitability after accounting for the required rate of return to keep the doors open.
How can you make residual income?
Some online business models offer a way to turn a residual profit. The trick is to find an area or niche you excel in and stick to it.
For example, if you teach piano in your community, you only have room for a certain number of lessons each day. Once you have enough students to fill the time slots, you’ve maxed out your income potential. But there is an opportunity for you to create residual income by moving online.
You might create an online course with video that takes people step-by-step through learning to play piano. You could also sell music instruction and study books, digital copies of sheet music, or set up a store to drop-ship piano accessories such as metronomes, polishing cloths, and piano benches.
Buying rental property is another option. Whether you collect money by renting the home to other people through a long-term lease or as a vacation rental on Airbnb, you have the potential to earn a passive income stream.
If being a landlord isn’t your thing, another option is real estate crowdfunding. Several online platforms exist that allow you to invest your cash and earn a return from real estate investment trusts (REITs).
You may have to invest a lot of work and money upfront to generate residual income. There is no guarantee that you’ll make a profit from your efforts and nothing lasts forever so expect to upgrade/update on a consistent basis. It’s smart to research your idea and the costs involved before you decide what business to go into.
How do you calculate residual income?
You calculate residual income based on the assets used to generate it.
If you want to know the intrinsic value of a company, you will use equity valuation. To find out how much a company is worth, you start with net income and subtract the equity charge, which is the cost of capital multiplied by the required rate of return on equity.
Figuring out residual income for your personal finances is much easier. Once you add up all of your income, subtract the total of your outstanding debts, such as your mortgage, car loan, or student loan.
Personal Residual Income = Total Income – Cost of Debts
For example, let’s say you earn $3,000 a month and have a $700 mortgage, $200 car payment, and $150 student loan payment. Your residual income is $1,950.
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