How I earn free money from passive income — with a bonus kicker!

My investment hero is American billionaire Warren Buffett. Over 35 years, I have increasingly relied on the Oracle of Omaha‘s advice to build wealth. In particular, I’ve become a passionate fan of passive income. This is money made without effort, without working, and while I sleep. As one investor remarked: “The greater the passive income you can build, the freer you will become.”

I buy assets for passive income

One way to generate passive income is by owning assets. For example, landlords earn rental income from property. Likewise, savers earn interest from cash deposits. And buying bonds (government and corporate fixed-income IOUs) delivers regular interest in ‘coupons’. But with near-zero UK and US interest rates, generating extra income is tough. For example, depositing cash in a top easy-access UK savings account would earn just 0.7% a year (before tax). Similarly, low-risk 10-year Gilts (UK government bonds) currently yield just 1.29% a year. I don’t expect to get rich on such returns.

I collect dividend income from UK shares

With interest rates so low, I risk my money in the hope of higher returns. That’s why my top asset for generating passive income each year is UK shares. Cheap shares from well-known UK companies can produce high income yields. This income comes in the form of dividends paid by companies to shareholders. Usually, these cash payments are made half-yearly or quarterly. However, I know from experience that company dividends are not guaranteed and can be cut or cancelled without notice. During the height of 2020’s coronavirus crisis, scores of UK-listed firms slashed or suspended their dividends. But most then resumed these (sometimes lower) payouts in 2021-22.

Admittedly, most UK-listed companies don’t pay dividends to their shareholders. These firms may be loss-making, or choose to reinvest profits to boost future growth. However, all but a handful of companies in the UK’s blue-chip FTSE 100 index do pay dividends. This index — which tracks the value of 100 of the UK’s biggest listed companies — currently offers a dividend yield of around 4% a year. That’s why the FTSE 100 is my happy hunting ground for passive income with scope to grow over time. Sure, this means taking a risk, but I’m comfortable with that.

Dividend investing comes with a bonus kicker

In order to maximise my family’s passive income, we own no bonds and keep only a modest cash reserve. Our portfolio is built on solid businesses that pay attractive dividends with the potential to rise over time. Furthermore, when dividends do go up over the years, share prices often follow suit. This means that, as well as generating passive income, dividend investing comes with a kicker (a free bonus). Here’s one simple example of how this works.

Let’s say I buy a share for £1 that pays 5p a year in dividends, producing a yearly dividend yield of 5%. Now let’s say that this company triples its yearly dividend pay-out to 15p over several years.  That’s a 15% dividend yield on my original £1 purchase price. But maybe the share price has also tripled, rising to £3. Now I’m still earning 5% a year, but my investment’s value has tripled. Over decades, this combination of passive income, rising dividends and capital gains has generated outstanding returns for us. That’s why we keep buying UK shares we think are good value for their dividends!

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.