How do DRIPs work?

As you can probably guess, we aren’t talking about those annoying leaks in your kitchen faucet. In investing speak, a “DRIP” is a Dividend Reinvestment Plan. How do DRIPs work?

With DRIPs, the dividends that you receive from a company are automatically reinvested in more of that company’s stock. You’re “dripping” money into your holdings with each dividend payout … and that adds up over time.

Let’s take a look at some of the advantages of DRIPs:

  • You don’t need a large amount of money to start: Many people think that investing is just for the rich. But usually, owning one share is all that’s required to enroll in a DRIP.
  • Your dividends are put to better use: With DRIPS, you’re using dividends to purchase more shares of the company instead of just spending the money or letting it sit in a low-return account.
  • You can bypass brokers and brokerage commissions: With a company-run DRIP, you can purchase shares directly from the company (or its agent) instead of from a broker.
  • You can purchase additional shares for little to no cost: Most companies allow investors to purchase additional shares through a DRIP for nominal fees — or often no fee at all. These stock purchase provisions are sometimes called Stock Purchase Plans (SPPs) or Optional Cash Purchase Plans (OCPs).
  • Many DRIPs offer discounted stock prices: These discounts can range from 1% to 10% below the current market price. Some companies, however, only discount shares bought with dividends, AKA not new shares.
  • You can buy fractional shares: Your dividends will be reinvested into additional shares of company stock, even if they just buy fractions of shares.
  • You gain some protection from market volatility: With DRIPs, you’re dollar-cost averaging—accumulating shares in a company by regularly investing a set amount of money. When the price is low, your money buys you more shares, and vice versa.
  • DRIPs encourage a long-term, buy-and-hold approach: Here at The Motley Fool, we believe in investing for the long haul. And that’s one of the reasons we love DRIPs — they “force” investors to buy stock on a regular basis and hold on to that stock.

Keep in mind that DRIPs, unfortunately, aren’t magical. If you’re reinvesting dividends to buy more shares of a company, there’s still a chance that your investment will drop in value. And if you need the income from dividends, DRIPs obviously aren’t the right call.

Types of DRIPS

  • Company-run: Many companies run their own DRIPs, although not all plans are managed in the same way. Company-run DRIPs are administered from corporate headquarters, usually as part of the company’s investor relations efforts. Oftentimes, companies that operate DRIPs themselves will allow investors to buy directly from them instead of from a broker.
  • Transfer agent-run: Managing DRIPs can be cumbersome, so many companies turn to third parties, called transfer agents – financial institutions that run DRIPs for a number of companies. Because they use the same resources for a roster of customers, transfer agents can often provide DRIP management services at a lower cost than the company could achieve by itself.
  • Brokerage-run: Some brokerages allow shareholders to reinvest dividends at no cost, even if the company in question doesn’t have a formal DRIP itself. However, these brokerage-run DRIP “simulations” apply only to dividends and don’t permit optional cash purchases like many company-run DRIPs do. And keep in mind that they could come with brokerage commission fees.

The Foolish bottom line

DRIPs are an easy and inexpensive way to increase your equity position in some top-notch companies. Once you’ve set up your DRIP account, you can sit back and watch your investment grow.

Of course, buying a company through its free DRIP is the most economical route. But if a company you’re considering doesn’t have a DRIP, think about opening a brokerage-run DRIP account — you might have to pay some commissions, but your gains will likely be well worth the cost.

For more info on DRIPs, tune into our Market Foolery podcast on Options and DRIP investing. To learn about when dividend reinvestment can be a bad idea, watch Dan Caplinger’s informative video.

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