24/02/17Everything you need to know about Innovative Finance ISAs

A new kind of ISA (Individual Savings Account) was announced by the government last year, which promises higher returns than traditional Cash ISAs.

What is the Innovative Finance ISA or IFISA for short? How does it work? And is it right for you?

Essentially the Innovative ISA allows you to use some, or all, of your annual ISA investment allowance, currently £15,240, to access the growing peer-to-peer lending market.

Whilst the interest rates being quoted may sound attractive, peer-to-peer lending exposes your capital to substantially higher risks than a Cash ISA.

How they work

The Innovative Finance ISA is the latest addition to the ISA family. This new product will allow investors to earn tax-free interest on their peer-to-peer loans.

Peer-to-peer lending essentially matches borrowers with investors. Your investment is pooled with the capital of other investors and then lent out to a number of borrowers. Your return is the interest they pay, less costs.

The number of borrowers you are exposed to will vary with each peer-to-peer lender. They are generally individuals, perhaps wanting cash for a new car or a house extension. In common with a traditional loan, they pay the money back over time, with added interest.

The rates offered by Innovative Finance ISA providers certainly look to be higher than those of conventional Cash ISAs. But, there is of course additional risk attached to such an investment.

Peer-to-Peer lending, the risks

Peer-to-peer lending should be seen as an investment, where your capital is at risk, and not a form of savings. It cannot be compared on a like-for-like basis with a Cash ISA.

There are two key risks.

Firstly, whilst peer-to-peer lenders are now regulated by the Financial Conduct Authority (FCA), they are not part of the Financial Services Compensation Scheme (FSCS) in the same way banks and building societies are. Therefore, if your peer-to-peer lender goes bust, you could lose all your capital. In contrast, providing you hold less than £85,000 in a savings account with a bank or building society which is part of the FSCS, your capital a guaranteed.

Secondly, if borrowers fail to make their repayments and default on the loan, you could see lower returns than you expected or even a capital loss. Most peer-to-peer providers spread loans across many borrowers and aim to make up any shortfall in the case of defaults, but nevertheless your returns and capital remain at risk.

Despite a track record approaching a decade, many financial experts are still sceptical about peer-to-peer lending. For example, Lord Turner, former lead of the Financial Conduct Authority cautioned that the lending platforms may not make proper checks on their borrowers.

He said: “We need to encourage people only to participate in this if they have money which they can afford to lose.”

In his view, lending money to small and medium businesses, can only be done with “good credit underwriting”

“The idea you can just automate that onto an [online] platform will end up producing big losses.”

However, he has since moderated his views, telling Financial Times, “[P2P lenders] … might be able to do credit underwriting as well as established banks and also aspire to offer better customer services.”

Should you invest now?

It’s certainly easy to see why savers may be tempted by the higher rates advertised by peer-to-peer lenders. However, it should be seen as an investment, where your capital is at risk and returns far from certain. Rather than a like-for-like alternative to a Cash ISA.

If you are considering an Innovative Finance ISA, it is important that you fully understand the potential pitfalls.