Least well known in the family of Individual Savings Accounts is the Innovative Finance ISA. These are not traditional cash deposits, but neither are they stocks and shares. So what’s to like, and not to like, about this alternative option for tax-free investing?
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 day-to-day volatility associated with stocks and shares ISAs. In the overall scheme of investment risk, peer-to-peer lending is more risky than cash deposits, but not quite as risky as investing in shares. Or rather, the risks are different.
Rather than your money being used to invest in well established businesses on the stock market, it’s on loan to individuals and small businesses. So the risk is more to do with the ability of borrowers to repay their debts.
Like any type of investing, diversification is important, so make sure you invest in a platform that pools your money across many borrowers. That way, if one borrower defaults, it doesn’t wipe out all of your investment.
If lending your money sounds appealing, you’ll need to do a fair bit of research. 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
You can expect higher returns than Cash ISAs or any other type of bank or building society account. That’s the reward for accepting the additional risks.
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.
In fact, some IFISAs specialise in helping your money to do good, such as lending money to small business that focus on ‘green’ projects. This can include renewable energy, fair trade, social housing and organic farming, for example. You can read more about this, with some suggested platforms to research, in this article by Good With Money.
There can be tax benefits too. Like all other ISAs, there is no income tax to pay on the interest you earn. So basic rate taxpayers could potentially save 20%, with higher and additional rate taxpayers saving 40% or 45% tax.
Having said that, with the introduction of the personal savings allowance in 2016, the tax-free nature of IFISAs is of little benefit to many. Basic rate taxpayers would need to earn more than £1,000 of interest per year to notice a tax advantage. The benefit to higher rate taxpayers kicks in after £500 of interest per year. Additional rate taxpayers stand to gain most because once you’re in the 45% tax bracket, your personal savings allowance is reduced to zero.
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. Alternatively, a regulated financial adviser may be able to help.
This article by Which sheds some more light on what you should read up on before proceeding.
Unbiased also offer some guidance, with a list of suggested platforms that you may wish to research.
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 an intriguing investment option, although they remain relatively 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 perhaps there’s a reason why some small businesses and individuals are not getting loans from the banks. Bear that in mind when you think about lending your money. With the absence of FSCS protection, you need to do your own due diligence.