What is Residual Income? Definitions & Examples
EG
Summary:
Residual income is a tricky term to define because it means completely different things depending on the context. For example, one meaning is the the income that continues to be generated after you’ve finished the income-producing work, such as royalties. However, in the context of personal finance it typically means the money that’s left from your income when you subtract your total expenses.
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What is residual income?
There are three main definitions for residual income.
- In personal finance, it refers to the difference between your income and your monthly bills. In other words, it’s what you have left each month after paying for non-discretionary expenses, such as food, clothing, or rent. This general meaning can also apply to corporate finance.
- In the case of corporate finance, residual income generally refers to a company’s profits after it pays for the costs of capital (including the opportunity cost of choosing one investment over another).
- Residual income can also refer to a type of passive income. Classical examples of residual income include royalties, rental/real estate income, interest and dividend income, and commission for the sale of products or services you are not directly involved in.
Let’s dig a little deeper into these meanings and provide some examples.
What are the different types of residual income?
The term residual income is used in a few different contexts, and the meaning is slightly different depending on whether you’re talking about corporate finance or personal finance.
Corporate finance
In the world of corporate finance, residual income refers to a company’s economic profit above its minimum required return. Companies use this figure to assess performance and whether they’re making enough money for continued growth. In other words, is the investment meeting — or exceeding — their expectations?
You can calculate residual income in corporate finance using the following formula:
Equity valuation
Residual income can also be used in corporate finance as a form of equity valuation. This calculation assumes that a company’s stock value is equal to the present book value of the company plus future residual income. This method is just one of many that can be used to determine the intrinsic value of a company.
Personal finance
The meaning of personal residual income isn’t all that different from its meaning in corporate finance. It’s the amount of money you have left after you pay for your monthly expenses and debt payments.
Your residual income is an important figure for your personal budget. It helps you to know how much money you have available to spend on necessities, including rent, groceries, and other expenses.
However, it’s also important to lenders when you’re borrowing money. When you apply for a loan, a lender wants to know that you have plenty of money left after your housing and debt payments.
Residual income vs. passive income
You’ll often find the terms passive and residual income used interchangeably. When used in this sense residual income and passive income are the same thing. It’s probably best to use the term passive income to avoid confusion.
Passive income (aka residual income) is a type of income that doesn’t require trading time for money. It continues even after you’ve made whatever initial time or monetary investment is necessary, meaning it’s the opposite of active income.
These types of income differ from active income, which is the result of actively working for the money you earn. You may receive active income in the form of a salary or hourly paycheck.
Is residual income taxable?
Yes, residual income (as a form of passive income) is taxable. You can learn more about how the IRS taxes residual income here.
You must report your residual (passive) income when filing your taxes. This can get a little complicated, so it’s a good idea to use tax preparation software or hire an accountant. If you decide to use tax preparation software, use the comparison tool below to find the best option for you.
How to increase residual income
It depends on what you mean by residual income. If you are referring to the budgeting term — what’s left after you’ve paid for non-discretionary expenses — then the best way to increase your residual income is to make more money and spend less. So, lower your expenses and increase your revenue, and your residual income will increase.
If you are referring to “passive income” then you should look for investments that take care of themselves once you set them up, such as real estate investing (the passive kind, managing a block of apartments is anything but passive), stocks, bonds, investment accounts, and royalties.
Here are just a few ideas to help you create residual income and have a bit more money for your financial goals.
1. Invest in real estate
Real estate is one of the most popular investment opportunities. Buying a rental property requires a large upfront investment, but after that, you could have an additional stream of monthly income. And once the mortgage on the property is paid off, your monthly income will increase significantly.
“Real estate investing” includes everything from crowdfunding a property to house hacking. Many people start small with house hacking, where they buy a home or duplex, live in a part of it, and then rent out the rest to a tenant.
Is rent residual income?
Any type of income, including rental income, can be residual income as long as you have it left over after you pay your monthly bills.
2. Buy dividend stocks
Many people buy stocks as a long-term investment so they can sell them for an appreciated value down the road. But another way to earn money from stocks is by investing in dividends, which is when a company passes along a portion of its profits to the shareholders.
While companies aren’t required to pay dividends, many do on a regular basis. You can choose to either invest in individual companies that pay dividends or buy shares in a dividend mutual fund or exchange-traded fund (ETF), where all of the stocks within them are dividend stocks.
3. Invest in bonds
Similar to stocks, bonds are another way to earn a recurring income from your investments. When you buy bonds, you’re essentially lending money to the issuing entity, which is either a company or a government body. And just like you pay regular interest when you borrow money, bond issuers make regular interest payments to bondholders. Once the bond matures, you’ll get back your full principal that you can either keep or invest in something else.
4. Royalties
Royalties are the gifts that keep on giving. A company may pay royalties to an individual or separate entity to use a copywritten idea, franchise, or patent. One of the most common examples of royalties is found in the music business. In this case, the musical artist receives royalties every time their song plays on the radio or in a television program.
5. Sell your hobby creations or digital products
Another way to earn some extra money is to sell digital or physical products online. Maybe you have several blankets you’ve knitted over the years, or you’re an amateur photographer with a great collection of pictures. Since you already made the products, it won’t take much work to offer these products through an online business.
How do mortgage underwriters calculate residual income?
Mortgage lenders will often use your residual income as a way of determining if you can afford a loan. For example, the Housing and Urban Development defines instructs offers the following instructions to calculate residual income when underwriting a loan.
Residual income may be cited as an acceptable compensating factor for qualifying ratios as described in Handbook 4000.1 II.A.5.d.viii.
Residual income is calculated as total effective income of all occupying borrowers less:
- state income taxes;
- federal income taxes;
- municipal or other income taxes;
- retirement or Social Security;
- total fixed payments (includes total Mortgage Payment and monthly obligations on all debts and liabilities);
- estimated maintenance and utilities;
- job-related expenses (e.g., child care); and
- the amount of the gross-up of any non-taxable income.
However, lenders will use different standards and requirements to determine eligibility. So, it’s always a good idea to compare multiple lenders when shopping for a home loan.
Key Takeaways
- In corporate finance, residual income is the profit that exceeds a company’s operating costs.
- In personal finance, residual income often refers to the amount left after you pay your bills and debt payments.
- Residual income is sometimes also used as another word for passive income or money that requires little to no effort to generate once a system is in place.
- There are plenty of ways to increase your residual income. This includes lowering your expenses, increasing your revenue, investing in bonds, obtaining royalties, or selling digital products online.
EG
Erin Gobler is a Wisconsin-based personal finance writer with experience writing about mortgages, investing, taxes, personal loans, and insurance. Her work has been published in major outlets, such as SuperMoney, Fox Business, and Time.com.
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