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How I’d invest £500 per month to build a passive income

If you’ve decided to start investing in 2020, then congratulations!

In this age of low interest rates, I believe that the stock market provides one of the few opportunities available for small investors to build a worthwhile passive income.

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Save with an ISA

The first step I’d urge you to take is to open a Stocks and Shares ISA. Like Cash ISAs, these accounts are tax-free. So any income or capital gains you generate through investing will never be taxed. Over the years, this can lead to some big savings.

Lots of brokers offer Stocks and Shares ISAs. But for good value and reliable service, I think the easiest option is to choose one of the big names. These tend to have modern, reliable websites and decent customer service. Hargreaves Lansdown, AJ Bell, and Interactive Investor are all popular choices.

The easiest way to get started

The easiest way to put your cash to work is to start paying into a low-cost FTSE 100 index fund each month. The FTSE 100 offers a dividend yield of 4.3% at the moment, so you’ll benefit from a decent income and the potential for capital gains.

If you’d like to build a passive income, you’ll need to make one important decision at this point. Do you want to start withdrawing income today, or are you investing for the future?

If you want income from your investments immediately, then you’ll need to buy distribution or income units when putting cash into a fund. This means your dividends will be paid out to you in cash, probably every six months.

If your aim is to build a fund to provide you with an income in the future – perhaps when you retire – then you’ll probably want to buy accumulation units. Doing this means your dividends will be automatically reinvested in the fund, boosting your returns and allowing you to benefit from the wonders of compounding.

Do you want to buy stocks directly?

I think that index funds are a great way to invest. But as a stock investor myself I understand the attraction of owning shares directly.

If you’d like to start investing in stocks with £500 per month, my suggestion would be that you plan to make a purchase every second month. That way, you’ll keep your dealing costs down to around 1% of the amount invested, based on a typical £10 dealing charge.

Since we’re focusing on passive income, my next suggestion is that you should focus on high-yield dividend stocks from the FTSE 100 and FTSE 250.

Given that the FTSE 100 offers a yield of 4.3%, I think we need to aim for a yield of at least 5% to make it worth investing in individual stocks.

To pick your stocks, you’ll need to get hold of some market data. As a minimum, you’ll need a list of the stocks in the FTSE 100 and FTSE 250, including forecast earnings and dividend yields.

I’d aim to pick 10 to 20 stocks from different sectors, adding one to your portfolio every two months.

By the end of the second year, you should have a portfolio generating an income of at least 5% – around £600 per year. Reinvesting this income, if it’s not needed, will enable you to speed up your purchases and enjoy larger payouts in the future.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Hargreaves Lansdown. 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.