It doesn’t feel controversial to say that having a second income stream from investing can be incredibly useful. That extra cash can help to pay bills, buy necessities, and generally keep the wolf from the door.
But a second option exists, albeit one that takes a bit of discipline. This involves reinvesting that money back into the market, allowing compounding to work its magic and reaping the (far larger) rewards further down the line.
Let’s look at an example of how this alternative plan might work in practice using the maximum annual ISA allowance of £20,000.
The go-to destination for second income
It’s possible to find examples of businesses of all sizes in the UK stock market paying dividends. But many people gravitate to those in the FTSE 100.
This makes intuitive sense. After all, the index includes some of our largest and best-known companies. But some of these also have unbroken track records of distributing cash to shareholders behind them.
Now, one could buy a tracker fund and be done with it. This would deliver the market return and dividends on top. For the FTSE 100, the yield currently stands at 3%.
However, those aiming for a higher-than-average level of passive income will need to buy individual company stocks instead.
This can involve more risk, but, as we’ll see, it has the potential to lead to eye-popping levels of income in time.
Huge dividend yield
One example of a firm offering above-average dividends is financial services giant Legal & General (LSE: LGEN). At 7.1%, the dividend yield is among the highest in the FTSE 100 and more than double that of the index as a whole.
Based on this, someone investing the full £20,000 would generate income of £1,420 in the current financial year.
As good as this is, let’s look at what happens when compound interest is allowed to run free.
Let’s say an investor always reinvests that money. Using that 7.1% as an average over 30 years leads to a final pot of £156,572.
Assuming the yield stayed the same, this would now deliver a monthly second income of £926. Using the same strategy, the aforementioned FTSE 100 tracker fund would generate just £287 per month.
I know which I’d rather have!
And — remember — we’ve not added any money to the original £20,000.
A word of warning
Obviously, there are caveats to this. A company’s dividend yield never stands still (it goes up or down depending on the share price, all other things being equal). Dividends can never be guaranteed, either.
As far as Legal & General is concerned, the firm operates in a very competitive space. A prolonged economic downturn could force many people to put off saving for the future. This would impact earnings and possibly impact how much cash is returned to investors that year (if any!).
But this is precisely why I prefer to own a bunch of dividend-paying stocks rather than relying on one or two to protect my second income. Theoretically, this ‘safety in numbers’ approach should mean that those companies doing well pick up the slack from those that aren’t.
Fortunately, Legal & General certainly isn’t the only income stock that we like the look of right now!
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Paul Summers has no position in any of the shares mentioned.
This story originally appeared on Motley Fool
