How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a portfolio of high-yield dividend shares.

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Building a reliable passive income stream has long been a goal of mine. I’ve tried several different methods, from selling photographs to writing books and other various side hustles. The one I found that requires the least amount of effort is investing in high-yield dividend shares.

It does, however, require patience and consistency. Like any profitable endeavour, it must be developed over time with slow and consistent growth. 

But there are a few tips and tricks I believe will make it easier.

Selecting the right stocks

It’s important to spend time selecting the right dividend shares. I found that while some companies have very attractive yields, the high payout ratios make them less reliable. A payout ratio is the total sum of annual dividends divided by net income. Companies occasionally have to skip dividend payments if income isn’t sufficient to cover them. 

So I think it’s important to include a range of different shares in a dividend portfolio, from reliable low yields to more profitable (but potentially less reliable) high yields.

One example is Barclays (LSE:BARC). This well-known UK bank pays a 4.4% dividend yield. With 334 years of business behind it and a £27.3bn market cap, it’s a well-established and reliable company. Shareholders enjoyed 32% returns over the past year – double the UK banking industry average of 15.8%.

The bank earns 28p per share issued and only pays out 8p, so its payout ratio is 29% – more than sufficient to cover payments. What’s more, the dividend is forecast to increase to 6% in the next three years.

However, the banking industry is particularly susceptible to risk in the event of an economic downturn. With Barclays heavily exposed to risky leveraged loans, a recession could lead to cascading defaults that would spell trouble for it.

Increasing competition from fintech-powered ‘neo-banks’ is another risk factor. Modern digital banks with no physical offices and lower overheads are threatening the traditional sector. Barclays must innovate and evolve if it hopes to compete against the rapid rise in modern digital rivals. 

The above risk factors reinforce why it’s important to have a well-diversified portfolio of shares.

Besides Barclays, the majority of my dividend portfolio is currently weighted towards Vodafone (11%), Imperial Brands (8.4%), Aviva (7%) and Shell (4%). Altogether, it provides me with an average dividend yield of 7%.

Building my passive income stream

By investing £12,000 into a portfolio with an average yield of 7%, I can expect £840 in dividend returns annually. If I reinvest that £840 each year for 20 years, my investment could grow to £48,000, providing £3,223 in annual dividends. 

That’s not much.

However, I must account for annual share price increases. The FTSE 100 has historically returned around 7.7% per year since it began but I’ll go with a conservative 6%. Add that to a 7% dividend yield and my 20-year investment could reach about £142,900, providing £9,000 in annual dividends. 

That’s not bad but it could be better.

If I contribute an extra £100 to the investment every month, it could grow to £242,170 in 20 years, netting me £15,300 in dividends – or £1,275 a month!

Finally, I would invest via a Stocks and Shares ISA which allows tax-free investments of up to £20,000 per year.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

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 assessed. Consider taking independent financial advice.

Mark Hartley has positions in Aviva Plc, Barclays Plc, Imperial Brands Plc, Shell Plc, and Vodafone Group Public. The Motley Fool UK has recommended Barclays Plc, Imperial Brands Plc, and Vodafone Group Public. 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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