What Is Residual Income and How Does it Work?
October 22, 2020
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If you’ve read any personal finance tips, you’ve probably seen the term residual income.
Residual income (RI) can mean different things. In personal finance, RI means the income you the income you have left over after paying outstanding debts.
We’ll focus on RI in personal finance and how increasing your personal RI will help you get approved for a loan.
Residual income vs passive income
RI and passive income are terms easily confused, but the two are completely different.
RI (in personal finance) is your leftover income after paying off your debts. So it’s not actually a form of income. It’s an equation to tell you how much money you have left over after paying what you owe.
Passive income is money earned in a way that doesn’t require constant work. A common example of passive income is owning a rental property.
If you rent a property to someone else, they pay you rent, which is income. Because the rent is income you collect without spending time at the rental, it’s passive income.
So RI might be from passive income, but passive income isn’t always residual.
Residual income in personal finances
RI is key to staying on top of your personal finances. When talking about personal finance, another name for RI that’s commonly used is discretionary income.
Remember, RI is your income after paying debts.
If you know what your RI is every month, you can make sure you’re not spending too much so you can keep up with your debt.
After you have a handle on your personal RI, you can grow it by paying off outstanding debt.
How do banks and lenders use residual income?
Increasing your personal RI gives you more financial security, but it also helps with qualifying for a loan.
Your personal RI is one of the main factors banks and lenders look at when deciding if they want to approve your loan.
The reason why RI is so important to getting a loan is because it tells the lender how much extra money you have every month.
If you get approved for a loan, you’ll have to pay it back with interest. To do this, you’ll need money that’s not tied up with your other expenses. So banks and lenders use your personal RI to see how easy (or how difficult) it will be for you to pay back the loan.
This process is known as determining your creditworthiness.
People who are able to show a high RI are more likely to be approved for a loan. If your RI is low, then the bank or lender may question your ability to pay back the loan with the amount of extra money you have on hand every month.
That’s why paying attention to your RI is important. If you can grow your RI over time, you’ll be in even better shape.
Increasing your residual income
The only way to increase your RI is to decrease your debt or increase income, which is much easier said than done.
The first step is tracking your current outstanding debt.
What loans are you paying off right now? Car payment? Credit card? Keep track of all your debt, and pay attention to how much of your monthly income goes toward paying that debt.
After you understand your debt, check to see if there’s a way to pay it off faster. Can you make larger monthly payments? Lenders are usually happy to talk about your loan options, so it’s always worth a call to ask.
Do you have many sources of debt that seem impossible to pay off? No worries—even people with lots of debt can work to raise their personal RI.
One common way to raise your RI while dealing with high levels of debt is a debt consolidation loan, which can gather all your outstanding debt under one loan, hopefully with a lower interest rate.
Everyone has their own financial situation to deal with. But whatever that situation is, working to increase your RI will help.
Staying on top of outstanding debt can be overwhelming even for the most financially responsible people. With the positive mindset and a little planning, it’s possible to overcome that debt and grow your residual income!
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