How I plan to make passive income with just £3 a day

There are multiple ways to make passive income in 2022, but our writer considers a popular method that involves dividend shares.

Passive income text with pin graph chart on business table

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To earn passive income, owning high-dividend-paying shares has several advantages. First, it can be much more passive than various other strategies.

For instance, I could own a buy-to-let property and receive rental income. But it turns out that in reality it’s not exactly passive, given the property maintenance needed to fix leaky plumbing or broken boilers.

With dividend shares, once I’ve selected the best options I can hopefully just sit back and watch my dividend income roll in passively.

Finding passive income from shares

So how do I find the best shares for passive income? With more than 2,000 shares listed on the London Stock Exchange, I’d want to narrow down the list to just a handful.

First, I’d explore British shares with the largest dividend yields. Towards the top of the list will be those that offer some unbelievable yields. There are several shares that appear to have 30% + dividend yields. But a word of warning.

If something looks too good to be true, it often is, in my experience. Some particularly high dividends are at risk of being cut or suspended. Instead, I’d focus on reliable income instead. Some companies have excellent track records for paying consistent dividends.

Top of the stocks

So if 30% is too high, what is a good range when looking at dividend yields. I reckon the sweet spot for passive income shares is currently 4%-10%. As a comparison, the average FTSE 100 share has a yield of 4% right now.

Next, I’d want to ensure the companies can afford to keep paying me these dividends. A common feature used to measure affordability is dividend cover. That tells me how well its dividend is covered by its earnings, and I’d look for a dividend cover of at least one.

Finally, I’d prefer to spread my risk across different industries. That way, if one sector faces a crisis it shouldn’t do too much harm to my total portfolio.

Considering all of these factors, I’ve narrowed down my list of shares to BHP Group, Direct Line Insurance Group, Phoenix Group, Imperial Brands, Luceco, Royal Mail and SSE. On average this list of shares offers an annual 8% dividend yield. Sweet.

Bear in mind that the price of the shares could fall in the short term. But if I plan to remain invested for several years, history suggests that my total return should be positive.

Watch it rolling in

How much passive income could I make with just £3 a day? If I add up these tiny investments over a year, I’d be investing £1,095. With an 8% dividend yield, that means I could receive around £88 in income.

It might not sound like a lot, but it’s a start. Over time I could add more of my savings to this plan. If I don’t need to withdraw the income right now, I could reinvest my dividends instead.

If I buy more shares with my dividends, in effect I could earn dividends from my dividends. It’s like a snowball rolling down a mountain, and it’s called compound returns. The power of compounding is a mathematical feature that should amplify my investment return.

By using these methods, I should be able to earn a nice passive income to supplement my main earnings. Lovely.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

Harshil Patel has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands. 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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