In this final article of six about Individual Savings Accounts, we look at an alternative style of investing. Innovative Finance ISAs are not cash and they’re not stocks and shares. So what’s to like – and not to like – about peer-to-peer lending?
What is innovative finance?
“Innovation” means bringing ideas to life in the shape of new or improved goods and services. Innovative Finance ISAs (IFISAs) are a relatively new way for all of us to lend money to other individuals and small businesses. A tax-free way to invest in peer-to-peer lending and crowdfunding.
You could think of it as a method of using your savings to support other people to buy their home. Or to support small businesses in helping to grow the economy.
With innovative finance, individual investors are lending their money in exchange for income. Due to the risks involved, you can expect significantly more interest than a bank account would offer. You’ll be able to find deals offering 5%, 6%, perhaps even 10%.
But let’s go back to that word “risk” for a minute.
Innovative finance risks
This is not like investing in shares, so you won’t have the volatility or other risks associated with stocks and shares ISAs. In the overall scheme of investment risk, peer-to-peer lending is more risky than cash, but not quite as risky as investing in shares.
If lending your money sounds appealing, you’ll need to do a fair bit of research or seek independent, regulated advice. Innovative Finance ISAs are still quite new, having only been launched in 2016, and they make up a small proportion of overall ISA subscriptions.
A few headlines to be aware of:
- No FSCS protection: unlike the other types of ISA, your Innovative Finance investment will have no protection under the Financial Services Compensation Scheme. This means your money is at risk if the platform (ISA provider) goes bust.
- You can get back less than you paid in: you should make sure that you invest in a fund that diversifies risk over many different loans. But even still, if one or more borrowers default on their debts, you could lose out. Your capital and interest is at risk.
- These are illiquid: you can’t easily make a withdrawal if you need access to your money or if you change your mind. Expect to be locked in for the full term, which could be anywhere from 6 months to 5 years.
On the plus side, all IFISA providers need to be authorised by the Financial Conduct Authority, so at least there’s an element of regulation over the way in which platforms operate.
The benefits of Innovative Finance ISAs
As mentioned earlier, you can expect a higher income than Cash ISAs or any other type of bank or building society account.
You might like the idea of supporting other people and small businesses, rather than buying shares in more established companies. It basically cuts out banks and other institutional lenders by offering a more direct way for the public to lend money to each other.
The tax benefits are attractive because, like all other ISAs, there’s no income tax to pay on the interest you earn. So basic rate taxpayers could save 20% and higher or additional rate taxpayers could save 40% or 45% tax.
What research should you do?
More and more IFISA providers are becoming available and to help navigate through the options, you should ask questions like:
- How long has the platform been trading?
- What types of lending do they provide?
- Is your investment diversified across multiple borrowers?
- What are their arrears and default rates?
- Do they offer any safeguards against borrower default?
- Do they offer any compensation in the event of borrower default?
- Can you access your IFISA funds if needed?
- What happens if the platform goes bust?
Generally, you should only consider IFISAs for a small part of your overall savings and if you don’t fancy doing all the research, it’s probably best not to bother. Failing that, a regulated financial adviser may be able to help.
What are the restrictions?
You’re free to invest up to £20,000 per tax year into this type of ISA, or you can split your annual allowance over a combination of:
- Cash ISA
- Stocks and Shares ISA
- Lifetime ISA (maximum £4,000)
- Innovative Finance ISA
The minimum investment will depend on the platform you choose, but typically, this will be £100 to £1000.
It’s possible to transfer existing Cash or Stocks & Shares ISAs into an IFISA, but you must do this through the new provider in order to retain the tax benefits.
Other than that, you need to be over 18 and you need to know what you’re doing. In fact, you’ll need to prove that you understand what you’re getting into as part of the application process.
Providers will ask you to specify whether you are an “every-day” investor, self-certified sophisticated investor or a high net worth individual. You will also need to complete a short test to demonstrate that you understand the risks.
Innovative Finance ISAs are quite an intriguing investment option, although they remain pretty much untested and are certainly not ‘mainstream’. The idea of supporting small businesses or individual home-buyers will be appealing to some, especially with the attractive interest rates on offer.
But there’s likely to be a reason these small businesses and individuals are not getting loans from the big banks. Bear that in mind when you think about lending your money – if the banks won’t do it, should you?
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