How passive income generates free money for life (with a secret sauce!)

Passive income is unearned income that rolls in without work or effort. Here’s how I invest to generate extra income with a fantastic hidden kicker…

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A person holding onto a fan of twenty pound notes

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One of the world’s most successful investors, mega-billionaire Warren Buffett, once remarked, “If you don’t find a way to make money while you sleep, you will work until you die”. What the so-called Oracle of Omaha is promoting here is passive income. This is income earned without effort, without working, and even while sleeping.

Passive income comes from assets

Passive income is generated by assets. These include property/real estate (rental income), deposit accounts (savings interest), and government and corporate bonds (bond coupons). However, in our world of ultra-low or negative interest rates, it’s much harder nowadays to generate income from these three sources. The UK’s best easy-access savings accounts pay interest of roughly 0.7% a year (before tax). Likewise, ultra-safe 10-year Gilts (UK government bonds) offer a current coupon/yield of under 1.2% a year. Yikes.

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I rely on UK shares for dividend income

That’s why my favourite asset for generating income year after year is equities (stocks and shares). Today, UK equities offer some of the highest income yields globally. This passive income comes from cash dividends paid by companies to shareholders. Typically, these payments are made half-yearly or quarterly. That said, company dividends are not guaranteed and can be cut or cancelled at any time. Indeed, during the depths of 2020’s Covid-19 crisis, dozens of major UK-listed firms slashed or suspended their pay-outs.

Furthermore, most UK-listed companies don’t pay dividends to shareholders. Instead, they prefer to reinvest their profits to boost future growth. But the vast majority of companies in the UK’s FTSE 100 index pay dividends. This index — which tracks the value of 100 of the UK’s biggest listed companies — currently offers a dividend yield of around 4% a year. For me as an income-seeking investor, this higher passive income is worth the extra risk of investing in shares.

The bonus ‘secret sauce’ of dividend investing

Today, my family portfolio owns no bonds and keeps a single-digit percentage in cash. Instead, I aim to buy into quality companies that pay attractive dividends and, ideally, those with potential for long-term dividend growth. And as dividends creep up over time, share prices often follow suit. Hence, dividend investing for passive income also comes with a bonus kicker. Over the years, investing in the right companies can produce significant capital gains (profits from selling shares).

Here’s an example of this ‘secret sauce’, loosely based on a real shareholding that my family owns today. Let’s say that I bought one share for £4 in 2002. Twenty years later, the share price has grown to, say, £20. Also, this share currently pays yearly dividends totalling £1. Thus, my stock’s current dividend yield is £1/£20 = 5% a year. But I bought this stock for £4, right? So my running dividend yield is £1/£4 = 25%. But not only am I earning 25% a year (before tax) on my £4 purchase price. My original investment has quintupled to be worth £20 — a capital gain of £16 a share. Whoa.

This ‘Holy Trinity’ of decent passive income, rising yearly dividends, and capital gains is my core investment strategy. In 35 years of investing, nothing has generated better returns for my family than this deceptively simple strategy. Hence, it’s the approach I most recommend to friends seeking to build wealth slowly (rather than trading, speculating, or gambling to get rich quick). Learn more about my dividends with growth system here!

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services, such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool, we believe that considering a diverse range of insights makes us better investors.

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