Turning a £40k investment into £3,200 of passive income a year!

Many of us invest for passive income. We do this by investing in dividend stocks and take the quarterly, biannual, or annual payments as passive income. Dividends are by no means guaranteed, but if we pick wisely, they can be more dependable.

Today, I’m looking at how I can turn a £40,000 investment — equivalent to two years of ISA allowance — in £3,200 of passive income a year.

This requires me to invest in companies with an average 8% dividend yield. That’s high, but it’s certainly achievable.

Let’s take a closer look.

Sustainability

The sustainability of the yield is of considerable importance. Nobody wants to invest in a high-yielding dividend stock only to find the dividend is no longer sustainable a month later.

This happened to me last year. I invested in Persimmon and it’s sizeable dividend yield, only for it to be cut a few months later.

However, in my defence, I was rather misled. Persimmon estimated its fire safety pledge would cost just £75m in spring 2022. Six months later, the firm said the same work would cost £350m — around half of 2021 profits.

So we have to be confident that the company can sustain its dividend. I also need to look beyond the company’s own narrative.

A good place to start is the dividend coverage ratio (DCR). This measures the number of times a company can pay its current level of dividends to shareholders.

A healthy DCR is two or above. For example, Lloyds has one of the strongest coverage ratios — 3.04 — on the FTSE 100.

But it’s also worthwhile looking at companies with strong cash flow but have lower coverage ratios.

Picking high-yielding stocks

So as mentioned, to turn £40,000 into an income worth £3,200 a year, I need to invest in stocks that, on average, offer 8% in dividend yields.

That’s not easy, but it’s been made easier by fluctuations in the market. In fact, I’m looking more at financial stocks after the Silicon Valley Bank fiasco sent share prices falling — and the panic has largely been unwarranted. And when share prices fall, dividend yields go up.

But, of course, I don’t need to invest all my money now. I can invest in some stocks I like today, but identify others I like the look of and wait for an entry point that suits me.

So what stocks should I pick? Well, I’ve got plenty of companies to choose from. Many of them won’t offer much in the way of share price growth — that’s what historical data suggests anyway.

But collectively, these stocks could help me hit that 8% target and turn £40,000 into £3,200 a year.