3 steps to passive income for just £40 a week!

Passive income is one of my core objectives as an investor. The passive income I receive comes via stocks that pay dividends to their investors. These payments are by no means guaranteed, but if I choose my stocks well, I can be fairly confident that the yield will remain constant, or even go up.

But I often look to reinvest my dividends each year so that I can earn interest on my interest. This is a process known as compounding returns. The strategy helps me develop a bigger pot which one day will allow me to generate more passive income.

So let’s take a look at my three steps for generating passive income.

Step one: investing regularly

Investing regularly is key to developing my pot from which I can derive passive income. £40 a month might not sound like a great deal of money but, after a year, that’s more than £2,000.

It takes discipline to keep saving regularly even when I have other financial demands, but it will pay off in the long run. After 10 years, I’d have invested over £20,000.

With £20,000 invested in dividend stocks paying 5% a year on average, I would be receiving £1,000 a year in passive income. That’s not bad at all, but there’s a way I can enhance it.

Step two: compounding returns

Compound interest is the process of reinvesting dividend payments and earning interest on my interest. The longer I leave it, the more money I have in the end.

So if I were to invest £40 a week for 10 years, and invest in dividend stocks paying 5%, and then reinvest my earnings every year, after 10 years I’d have just over £25,000.

It’s also worth remembering that the general direction of the stock market is upwards. Over the past 10 years, the FTSE 100 has grown by 25%.

So with the index growth in mind, and the impact of compound returns, I would hope that my £40 a week would be worth around £30,000 after a decade.

Step three: picking right

So with £30,000 in dividend stocks paying 5%, I would be receiving £1,500 a year in passive income. Once again, that’s not a massive figure but the extra £125 a month could help with bills, or even pay for evenings out.

But it’s important that I pick my stocks right. I need to be wary that big dividends such as Persimmon‘s current 16.5% is probably unsustainable in the long run. And if I want consistency, I should look a coverage ratios — the number of times a company could pay dividends to its common shareholders using its net income — and dividend payments history.

I’d also be looking at stocks in fairly reliable sectors. Right now, I’m looking at banks because interest rates are on the rise and this will make a huge difference to their margins. I’m also looking at defensives, like Unilever, which should continue to perform despite the forecast economic downturn.