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Forget buy-to-let. I’m using dividend stocks to earn 6% per year

A survey published at the end of last year found that rental yields on UK buy-to-let property can range from just 2% to as much as 10%. It’s all about location. But there are other factors to consider too.

For one thing, these calculations didn’t include the cost of mortgage interest. Income tax wasn’t included either. Nor were agents’ fees, repair costs, or the risk of unpaid rent.

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I’d guess anyone buying property to rent today would struggle to generate a net yield of much more than 6%. In many areas of the UK, yields will obviously be much lower than this.

Tax-free 6% from stocks

I think the stock market offers much better opportunities for generating reliable income and long-term capital gains.

For example, most of my cash is invested in a portfolio of high-yield stocks which currently offers a forecast yield of 6.1% for the current year. I hold my shares in a Stocks and Shares ISA, so all of this income is tax free. Any capital gains I earn over the long term will also be tax free, unlike with rental property.

One fair criticism of my approach is that with housing you can use a mortgage to leverage your returns. For example, a £25,000 deposit will enable you to quite safely buy a £100,000 property.

The power of compounding

I wouldn’t recommend borrowing money to buy stocks. But my approach does offer another way to leverage returns. As I’m still working, I use my dividend income each year to buy more stocks. The following year, they also provide me with dividends.

This approach is known as compounding. Over time, it can deliver impressive gains. For example, £10,000 invested for 10 years at 6% (with income reinvested) would be worth £17,900. After 20 years, it would be worth £32,000.

In addition to this, the shares you buy will hopefully rise over time, generating capital gains.

How I’d build a 6% passive income stream

Building an income portfolio like mine is surprisingly simple. Here’s how I do it. The first step I’d take is to open a Stocks and Shares ISA or perhaps a SIPP pension. I’d choose an account with one of the main online brokers, such as Hargreaves Lansdown, AJ Bell, or Interactive Investor.

You’ll then need to build a list of stocks to buy. I usually focus on larger companies from the FTSE 100, with a few mid-sized firms from the FTSE 250. The reason for this is that these businesses are generally consistently profitable and better able to ride out short-term problems than smaller companies.

At this stage it’s important to choose a diversified mix of companies. I’d pick no more than one company from each sector, aiming for a total of 15-20 shares. You can buy these all at once, or over time as you have funds available.

Obviously we’re looking for a high yield, but we also want it to be sustainable. I tend to focus on stocks with a dividend yield of between 5% and 8%. But I’ll also choose some lower yields to help diversify the portfolio and improve dividend growth.

Once you’ve built your portfolio, you can keep topping it up with new savings, or just leave it to work, reinvesting the dividends every few months. The secret to success is patience — compounding is a reliable strategy, but it does take time.

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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.