Understanding Incomes

A sound financial health stems out of knowing the types of incomes and understanding their underlying fundamentals. Every rupee earned falls into one of two income types: active income and passive income. Active income is that for which a person is directly trading his time for. All salaried and self-employed professionals work for active income. When an individual reports to work, he exchanges his time for a certain amount of money as determined by his pay. This is also called earned income. Passive income on the other hand does not require a person's physical presence, but instead arises out of owning tangible assets like property, shares and bank savings or intangible assets (intellectual property). Rental income, dividends, interest on FD’s, royalty money from sales of books or records qualifies as passive income amongst others.

A word that comes with active income is 'instant gratification'. When a person jumps jobs for a higher pay, he sells his time for a higher price to his new employer. The biggest drawback that comes with earned income is that when a person stops working, his income stops. However, this is not true for passive income where the accompanying emotion is 'delayed gratification'. Traditionally, passive income takes time to build up and grows with the growth of the underlying asset class. But since this can take time, the underlying requirement is patience while developing a stream of passive income. The leverage factor is virtually unlimited for a person building passive income, whereas there is very little leverage for a person working for active income as the amount of time in each of our hands is limited.

In today's volatile economy, it is all the more essential for an individual to diversify his income from more than one income stream. Companies today are diversifying beyond their core businesses. If these giant corporations are thinking in terms of diversification, it becomes almost mandatory for a person to diversify his income streams as well. Relying on any one particular source of income is almost too big a risk for a common individual to take. The good news here is that every time active income flows in, there is a choice: either to expense it out directly; or convert it into an asset that can provide passive income at a later date. For instance, if a salaried person were to invest a portion of his income in a well chosen mutual fund on a regular basis, over a period of time he would find this asset block big enough to provide him a separate stream of income. This secondary income would be his passive income that comes in independent of his active income. Active income can be converted into passive income if nurtured and grown carefully.

Every individual can calculate his financial well being by working out his wealth ratio. Wealth ratio is the sum total of active income and passive income divided by a person's total expenses. A wealth ratio of greater than 1 says that an individual's financial situation is sustainable and looks healthy. A ratio of less than 1 indicates living beyond one's means. Another crucial factor is to ensure that passive income is at least as much as the active income. This indicates that if due to any unforeseen incident, an individual is unable to work; his lifestyle is still maintained by the passive income.

With this understanding, it is a matter of choice between having an active income and a passive life, or a passive income and an active life.