Are innovative finance Isas worth the risks?

Innovative finance individual savings accounts (Ifisas) have their roots in the fallout from the 2008 financial crisis and credit crunch. At that time, it became much harder for individuals and businesses to borrow from banks and other traditional lenders, at the same time as savers were frustrated by rock-bottom interest rates on their conventional bank accounts. Peer-to-peer (P2P) lenders such as Zopa, Assetz Capital and Funding Circle emerged as attractive alternatives to fill that void. These websites cut out the banking middlemen, acting directly as financial matchmakers between people with cash to lend and personal or corporate borrowers.

The industry has undergone meteoric growth: research by UK innovation agency Nesta and the University of Cambridge found that transaction volumes – the amount of money flowing through P2P lending platforms – grew from less than £100mn in 2011 to £2.9bn in 2015.

To encourage private investors to tap into the trend, Ifisas were launched by the government in April 2016. These are tax wrappers offered by P2P lenders which enable investors to accumulate P2P returns tax free. They can be held alongside cash, stocks and shares, and Lifetime Isas, and you can currently put £20,000 a year into Isas in aggregate.

But it's worth noting that most investors are not taxed on the interest they receive from P2P loans held outside Ifisas because P2P lending returns are covered by the personal savings allowance. This allows basic-rate taxpayers to receive interest from cash or certain types of debt worth £1,000 tax free, and higher-rate taxpayers to receive £500 tax free.

According to the independent P2P ratings website 4thway.co.uk, this means that basic-rate taxpayers can typically lend between about £12,000 and £30,000, and higher-rate payers between about £6,000 and £15,000, before being taxed. But an Isa wrapper removes any uncertainty about tax implications and is useful if you already use some or all of your personal savings allowance for interest from cash and bonds.

P2P investments

There are several different types of P2P categories, including loans to individuals and companies, and for property development. There are also crowdfunding opportunities with a social focus.

Most P2P lenders focus on property. Ben Yearsley, investment director at Shore Financial Planning who is personally an Ifisa investor, explains: “It provides investors with a degree of comfort and asset backing, assuming of course, that there is a first charge over the property lent against.”

He adds that other types of assets such as business equipment may also be used as security.  

The principle in each case is more or less the same: as an investor on a P2P portal, you’re lending to a specific type of borrower or basket of borrowers. And because there’s no bank involved you probably earn a notably higher rate of interest on your money than you would from an ordinary cash savings account.

To put that into context: top two-year fixed-term savings rates from conventional banks were around 2 per cent as of early April, according to comparison website MoneySavingExpert. In contrast, Ifisa provider Kuflink offers one-, three- and five-year opportunities to lend against UK property development schemes from as little as £100, with rates between 5 per cent and 7 per cent.

Not all Ifisas are fixed term products. For example, easyMoney offers a range of swift access accounts focused on property investments with interest rates between 3 per cent and 5 per cent, depending on the amount you have to invest. 

Higher risks for higher returns

These rates might turn your head if you’ve spent the past decade watching your cash earn increasingly miserly returns. But although Ifisas pay interest and look similar to cash accounts, they have significant risks.

Unlike with a savings account, the advertised return and security of your capital are not guaranteed. Risks include the borrower to whom you lend defaulting; the loan site going bust; fraud or negligence; lack of access to your money; and difficulty in spreading your investment across enough borrowers to minimise damage to your overall portfolio if any one loan defaults. And, in contrast to other types of Isas, your money is not protected by the Financial Services Compensation Scheme if the P2P platform via which you lend collapses. Some P2P lenders have contingency funds to cover such situations but they don’t guarantee that they will do this.

The risks involved, coupled with evidence that people were treating Ifisas like cash accounts, led the Financial Conduct Authority (FCA) to tighten the rules in 2019. You now cannot hold more than 10 per cent of your investable assets in P2P loans unless you have taken financial advice. And Ifisas can only be marketed to more experienced and high-net -worth investors.

As a consequence, evidence suggests that the Ifisa market is steadily shrinking. Government figures for 2019/20, the latest available, show that while the total number of adult Isas subscribed to was 13mn, only 34,000 of those were Ifisas. And that figure has fallen progressively, having stood at 49,000 two years earlier.

There are still around 30 P2P platforms that offer an Ifisa wrapper, although here too numbers have declined from around 40 three years ago. Those still offering an Ifisa include Assetz Capital, CrowdProperty, Downing and LendingCrowd.

Several P2P platforms have closed since 2019 because of the increased regulation or following allegations of bad practice over recent years. The fallout from the Covid pandemic caused further difficulties in the form of a rise in the number of defaults or late repayments, and led to widespread suspensions in retail lending.

Additionally, a number of leading platforms, including Ratesetter, Zopa and within the past few weeks Funding Circle, have left the retail market as a result of corporate restructuring. Funding Circle explains that following a two-year pause in new investment from private investors “as we navigated and adapted to the Covid pandemic”, the company has decided “now is the right time to close retail lending”.

In response to a request for a comment on prospects for Ifisas, P2P industry body 36H responded with the observation that “they don’t have anything to really contribute as this isn’t something their members have raised with them”. The industry body is called 36H to reflect that member platforms are fully authorised by the FCA under Article 36H of the Financial Services and Markets Act 2000.

It’s hard not to conclude that P2P platforms as a whole are really not focused on growing the retail market.

“It does feel like a slow death for the sector,” comments Yearsley. “Obviously there have been a fair few scandals that haven’t helped, added to the fact that rates for the safest Ifisas have fallen sharply too. There is something of a self fulfilling prophecy here – without funds from investors, providers can’t make promises to their end borrowers, and without scale it’s hard to operate in this market.”

Moreover, as we move into an era of rising interest rates, the dynamics within the industry are likely to shift. Rising rates will attract lenders, but make life more difficult for borrowers. And as Yearsley points out, they’re also likely to increase bad debts, “which will ultimately be bad for investors”.

His view is that although there remain “some decent players in the market”, rates are now too low to make Ifisas worthwhile for most investors. “Once rates have risen and plateaued might be a better time, if there are still providers around,” he says.

Ethical options

One area where there are interesting P2P and crowdfunding options is the ethical arena. For example, you can invest via an Ifisa in social bonds through Triodos Bank’s crowdfunding site. Those on offer include a renewables bond to refinance two community solar projects in the UK which pays 4.25 per cent interest which is inflation-linked and has a 16-year term.

Energise Africa also has an Ifisa through which you can invest in environmental projects in Africa and the three bonds it offers pay 5 to 6 per cent interest over 18-month to two-year terms. Lendwise, meanwhile, focuses on direct educational loans to postgraduate students, with personalised interest rates averaging 9 per cent, reflecting not just their credit score but also their future earnings potential.

Whatever route you take, investing in an Ifisa should never be confused or aligned with putting money into a cash Isa. It’s an inherently risky proposition, so do your homework, think carefully about the risks involved and only invest money that you can afford to lose.