For most people with a modest level of savings, there are two options for generating passive income.
The first is to earn interest on deposits placed with a bank or building society.
Today, it’s possible to open a savings account with Nottingham Building Society that pays 5.1% annually. And some economists are predicting interest rates to rise further.
An alternative is to use the stock market and earn dividends from owning shares in profitable companies.
The FTSE 100 is expected to yield 3.9% in 2023. Although lower than the best savings rates currently on offer, I’d hope to benefit from some capital growth too.
No guarantees
Of course, this isn’t guaranteed. Share prices can go down as well as up. And there’s no protection if a company goes bust.
In contrast, most UK savings accounts come with an £85,000 government-backed guarantee.
If a bank or building society goes under, deposits up to this amount are protected by the Financial Services Compensation Scheme.
Owning shares to generate income
But by investing in the largest UK companies that have the greatest financial strength as demonstrated by their strong balance sheets, the chances of suffering a total loss are reduced.
It’s also possible to invest in a FTSE 100 tracker fund. By holding one investment, risk is spread across all 100 companies in the index.
Personally, I’d opt for stocks and shares. But it’s important to take a long-term view when it comes to investing.
Investing for the future
According to the Office for National Statistics, the average amount of savings for an 18 to 24-year old is £2,481.
Assuming an interest rate of 5.1%, over 40 years this sum would grow to £18,144. But to achieve a seven-fold increase like this, it would be necessary to leave the interest earned in the account.
This demonstrates the power of compounding (earning interest on interest), which has been described as the eighth wonder of the world.
After 40 years, I could withdraw the interest each year and earn a second income of £925, assuming rates remain unchanged.
But my preferred approach would be to invest £2,481 in a FTSE 100 tracker.
Since the index was launched in January 1984, it’s delivered an annual growth rate of 7.4%, with all dividends reinvested.
If repeated, in 40 years’ time I could have a lump sum of £43,132. And annual passive income of £3,192, or £266 a month.
Better returns
However, it’s important to remember that past returns are not necessarily a reliable guide to future earnings. But I don’t have a crystal ball, therefore, history is all I have to guide me.
However, it’s worth repeating that the key is to adopt a long-term approach.
By investing for many years — preferably decades — there’s more of a chance of smoothing the inevitable downturns with periods of growth.
So I’d choose the stock market if I had some savings to invest. I think I could earn more passive income than if I left the same amount in a savings account.
