These days it feels like everyone is hunting for a passive income stream. A rising cost of living, stagnating wages, and desire to do and see more are making life expensive for me.
Lately I’ve been thinking about high-quality dividend shares that could help me out. After all, who wouldn’t want to bank a cheque each month without lifting a finger?
One thing that really got me thinking is compound interest. I thought I’d dive in and see which would be better for me: £100k today (by some miracle!) or a £5k annual income.
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Building a £5k passive income
First thing’s first, let’s think about where this money could come from. It could be from a side hustle, or in my case, I think some savvy FTSE 100 investments could do the trick.
The Footsie has an average 3.6% dividend yield right now. That means a £10,000 investment matching the large-cap index would give you £360 per year in dividends on average.
That’s pretty handy, given this would also be diversified amongst the largest 100 UK stocks. That includes well-known companies like Lloyds, J Sainsbury and BAE Systems.
So, if I wanted a £5k passive income that replicates the Footsie, I’d need to have £139,000 invested. The most efficient way I think I’d do that is to invest in an exchange-traded fund (ETF) that aims to replicate the index, such as the iShares FTSE 100 (LSE:ISF).
By size it’s the largest at over £12bn. It is also one of the cheapest with a 0.07% ongoing charge and has proven to be popular with passive investors.
Assuming the money is available to invest, the question then becomes: would I prefer a £5k annual income or a £100k lump sum today?
The magic of compound interest
Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
In my case, this compound interest could be reinvested dividends. It would be tempting to spend my hypothetical £5k per year income on having fun. I’m young enough, however, that I’ve got plenty of working years ahead of me.
Let’s say I had another 25 years until retirement. The magic of compound interest means that £5k annual income, if reinvested for 25 years at 3.6%, would be worth a lot more than £100k today. Plus, I’d be more likely to spend that lump sum in any case!
In fact, assuming annual reinvestment, that portfolio could grow from £139,000 to £349,000 by year 25. That represents £210,000 in gains just from reinvesting that annual yield.
By year 25, that portfolio would be throwing off over £12k per year in passive income. By then, I just might be ready to start spending on the finer things in life.
Is it possible?
Of course, this is a simplified example to show the power of compound interest and investing discipline. There’s no guarantee that the Footsie will continue to yield 3.6%, and the stock market will almost inevitably have its share of ups and downs in the next 25 years.
However, I think with some hard work and good investing, I can use dividend shares to build a passive income and set myself up for the future.
