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Why I’d ditch a Cash ISA to make a passive income with just £20 per week

Seeking to obtain a passive income from a Cash ISA is a hugely challenging task. With interest rates close to historic lows, it is difficult to obtain an income return from a Cash ISA that provides a generous passive income unless you have vast amounts of capital.

As such, investing even modest amounts in the stock market could be a much better idea. Not only do they offer the opportunity for long-term growth, indexes such as the FTSE 100 and FTSE 250 have a variety of stocks that provide high and fast-growing income returns today.

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Cash ISA challenges

Investing in a Cash ISA is unlikely to build a portfolio that is large enough to generate a passive income – even over a long period. Interest rates on Cash ISAs are generally lower than inflation at the present time, which means that they offer a negative real-terms return. Over time, this will reduce your spending power and cause your nest egg to feel smaller in terms of the goods and services it is capable of purchasing.

Furthermore, if you have a nest egg from which a passive income is sought, the low interest rate on a Cash ISA means that a large amount of capital income will be required to make even a modest income per year. For example, assuming an interest rate of 1.5%, you would need to have £585,000 in a Cash ISA just to equal the State Pension of £8,767 per year.

Stock market potential

By contrast, the stock market offers a much more attractive means of generating a passive income. The track record of the FTSE 100, for example, shows that investors can expect to achieve an annual total return that is around six times higher than the current interest rate on a Cash ISA. The index may have stuttered of late, but its track record since inception shows that a high-single-digit annualised total return has been recorded.

Assuming a weekly investment of £20 in the FTSE 100, an investor could accumulate a nest egg of around £350,000 over a 40-year working life. The same amount invested in a Cash ISA, which returns 1.5% per annum would be worth around £56,000 over the same period.

In addition, the FTSE 100’s 4.4% dividend yield could offer a passive income of £15,400 per annum from a £350,000 nest egg. This contrasts with the passive income return on a £56,000 Cash ISA after a 40-year period, which would amount to just £840 per annum.

Risk/reward

Clearly, the stock market is a riskier place to invest than a Cash ISA. An investor’s capital is at risk at all times. However, with interest rates expected to stay low over the coming years, anyone seeking to obtain a passive income from their capital may be better off considering the purchase of FTSE 350 shares to obtain a superior return in the long run.

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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.