The Difference Between Passive and Residual Income

The thought of earning money without doing any active work sounds pretty nice. When people talk about “earning money while you sleep” (even though that’s a myth), they’re usually referring to passive or residual income. Although the two terms are often used interchangeably, there are some key differences between them. Here’s what to know about the differences between passive and residual income, and what they mean for you bringing in some extra cash.

What is passive income?

In theory, passive income is what it sounds like: Money you earn without performing the active labour of a typical day job. This income starts to flow after putting in a certain amount of time or money upfront, with minimal ongoing effort after your initial investment.

Examples of passive income include renting a spare room through a home-share app or selling clothes online. Then again, most things that are considered passive income (real estate, book royalties, online sales, etc) take a lot more work and consistent effort than financial gurus would have you believe.

What is residual income?

According to Investopedia, there are three main definitions of what residual income means in different contexts (personal finance, corporate finance, or equity valuation). In personal finance terms — our primary concern here — residual income is any leftover income someone has after they pay all of their debts and bills. If you are applying for a loan, your residual income is used to help figure out your creditworthiness as a borrower. It’s essentially another term for discretionary income.

This definition means that residual income is often passive; it does not mean that passive income is necessarily residual. In fact, residual money from your main source of income could be used to support a new passive income endeavour. Both passive and residual income are taxable, although not at the same rates as active income.

The bottom line

While both residual and passive income can boost your financial security, passive income is going to have a greater impact, as explained on Indeed.com. Think about it this way: Let’s say you pay all your bills and reduce your debt by $US500 ($694) dollars one month, thus creating $US500 ($694) in residual income. If you also rented out a vacation home that same month, you might have made over $US1,000 ($1,388) in passive income — clearly a more significant gain. The caveat here, of course, is how you define “passive” when it comes to booking and maintaining that rental property.

Ultimately, when people are talking about extra cash flow with minimal effort, they’re referring to passive income over residual. You might need residual income to get your “side hustles” off the ground, and then that passive income can increase your total residual income — all the money remaining once your bills are paid.