Today, innovative finance individual savings accounts (IF Isas) offer anything from 4 to 12 per cent interest. That’s a very good incentive to buy one, particularly in this low interest rate environment. But are they too good to be true? And what exactly are the risks of investing through an IF Isa?
To understand this, we first have to look at how an IF Isa works. IF Isas were introduced in April 2016 as a tax-efficient way to engage in peer-to-peer (P2P) lending. Through IF Isas, investors can channel their money into personal loans, small business loans, property loans and other debt-based securities, provided they fulfil the eligibility criteria of an IF Isa. Many P2P platforms that are regulated and approved by the UK regulatory body, the Financial Conduct Authority (FCA), offer the IF Isa wrapper themselves to investors, as a way to lend through them.
You can invest some or all of your annual Isa allowance of £20,000 in an IF Isa and receive tax-free interest (and capital gains should there be any). The annual Isa allowance can be spread across different types of Isa, including a cash or stocks-and-shares Isa, and it does not have to be invested in a single lump. As with these older types of Isa, investors can only have one IF Isa each tax year, but can open a new IF Isa with a different provider each tax year. You will need to consider if an IF Isa is the best way to use your annual allowance.
A big draw for investors who use IF Isas is the chance to invest in P2P lending tax-free. The returns on offer from lending to individuals and small businesses typically beat those on offer from standard bank savings accounts. P2P lenders say they are able to offer investors such high interest rates because technological advancements mean electronic interfaces and automated processing reduce overheads. Additionally, P2P platforms do not have to adhere to the strict criteria that banks do when agreeing on who to provide loans to.
There are two ways in which money can be lent to borrowers through P2P platforms. The first is through pooling. As the name suggests, with this method, the platform pools money from a number of investors and then lends it to the borrower. So, in effect, an individual lender’s money is distributed across a number of borrowers. In the second method, investors can pick borrowers to lend to themselves, on an individual platform. Ratesetter pools money, but Capital does not.
Whichever option you pick, doing your own research is imperative because the risks are tremendous and investors are not protected by the Financial Services Compensation Scheme (FSCS). “You are relying on the platform to do due diligence, but you can’t as an investor leave it all up to them – you have to do your own research,” says Ben Yearsley, director at Shore Financial Planning. If lending to individuals for personal or property loans, then investors have to consider the creditworthiness of the individual and the strength of their contingency plan for repayments should the worst happen, for example the borrower losing their job.
A large number of loans that are available on platforms are business loans and “because businesses fail all the time, the risk is always high that you will almost definitely lose some money”, Mr Yearsley says.
“The higher the interest rate, the higher the risk you take on,” says Sarah Coles, personal finance analyst at Hargreaves Lansdown.
Although IF Isas are marketed as comparable to cash Isas, the products have entirely different risk profiles. Lending money to individuals or businesses that could be illiquid or go bust clearly carries higher risk, and crucially as mentioned above is not protected by the FSCS. Cash, by comparison, is low risk. Mr Yearsley says IF Isas “are comparable with a stocks-and-shares Isa in terms of risk. However, if a stock goes bad you can sell it, but with P2P lending your money can be tied up for a long time”.
“The level of risk depends on howrisky the company is that you’re lending to – which is incredibly difficult for investors to assess. In some notable cases, the borrowers have not used the money as had been promised, and investors have lost everything,” says Ms Coles.
An example of retail investor lending going horribly wrong is the story of London Capital and Finance (LCF), which was falsely marketing mini-bonds as fixed-rate Isas. “If a small, unlisted company raises money for itself, it’s called a mini-bond. They are not IF Isa-compatible. But if an FCA-regulated firm arranges the deal between the investor and the company and treats the investor as a client, then it’s called a bond and this is Isa-compatible,” explains Julia Groves, partner and head of digital at Downing, an IF Isa that packages loans as bonds.
Although LCF was FCA approved, the mini-bonds it pushed were not. Following the collapse of LCF in January, its administrator, Smith & Williamson, found a series of “highly suspicious transactions”, with funds going to the four men behind the company.
Investors should check what safety net each platform offers. But even where there is a reserve fund, built up using investors’ money, it can be difficult to know how much you can rely on these. “They can also give a false image because they only cover a small percentage of losses,” Mr Yearsley says. Some are very small, so it is worth checking how much is in the reserve fund. Reserve funds are also currently non-statutory and are run entirely at the discretion of the platform, so there is no guarantee that funds will be paid out. A platform’s reserve fund policies can also change over time.
Some platforms, such as Octopus Choice, take on a percentage of the risk first themselves, before any falls on the investors. Anthony O’Connor at Intelligent Partnership, a financial adviser education platform, says: “Octopus loses 5 per cent before you start to lose any.”
“Some platforms, like Ratesetter and Lending Works, have fully integrated reserve funds, so even if there’s only a little bit of loss, they pay out,” says Iain Niblock, chief executive of Orca Money, which offers investors access to different P2P platforms. Additionally, many platforms pay investors back before they recover their own losses. “A general rule of thumb is, the bigger the provider, the better the chance of repayment,” Mr O’Connor says.
Some of Downing’s bonds are seven-day bonds, so investors can access their money within seven days. Mr O’Connor says Downing “is at the lower end of the risk spectrum because it promotes bonds for which the company gives you first charge.”
Funding Circle, which was listed on the London Stock Exchange at the end of 2018, enables investors putting in at least £2,000 to diversify risk by spreading their money across at least 200 businesses.
Newer platforms may offer greater choice but have no track record, making it difficult to know which ones to trust. And P2P is also “a relatively new market that hasn’t yet been through a really tough time, with large numbers of defaults, so we don’t know how they’ll hold up when these safety nets are deployed”, says Ms Coles.
Mr Niblock also believes that it is important to consider the financial stability of the platform itself and to ask questions about how it has weathered the various stages of an economic cycle since it first started and what its risk management strategy is.
Although secondary markets exist for many platforms, a lender’s ability to sell their loan is dependent on the availability of a buyer. Most buyers are also likely to seek a discount on the face value of a loan, so cashing in mid-term could mean you accept a reduced amount from the buyer. Besides any risks posed by the platforms themselves, investors need to also consider the risks posed by the underlying holdings, in particular from highly risky small businesses.
Risk of business failure
The criteria for shortlisting borrowers for business loans is, naturally, different for each P2P platform. Mr Niblock says that typically “the process involves looking at whether the borrower can deliver the expected return, and the risk profile of the borrower so as to offer investors a variety of risk”. Following this, platforms also assess the business’s recovery process and risk management.
However, if investors pick individual businesses to lend to themselves or go for bonds, then Mr Yearsley says it is essential to read through “the 49-50-page document on each business”. Check if the loan is secured or unsecured. The latter naturally will carry greater risk, whereas a secured loan might mean investors get something back.
Mr Yearsley recommends looking at the value of a business’s assets compared with the value of the loan. For example, “if the company has £1m and has property worth £2m then loan-to-value is twice, so you look at that and see risk is lower”, he says.
Remember too that property values underpinning loans are not fixed and can fall. As Sam Ferris, communications executive at P2P lender Octopus Choice, points out: “It also matters what kind of property backs the loan. Some lenders will do development property, but it’s not helpful to have a half-built hotel when you need the cash. We tend to choose more liquid projects like a three-bed flat that someone is redeveloping. We also do a lot of buy-to-let.”
Creditworthiness of a business is also important, as is the quality of the management team. “For bonds, repayment depends on the success of the business,” says Ms Coles. “Most businesses set out some general principles, but you often won’t get much detail on this, so it comes down to whether you’re comfortable with that.” But she notes: “This can be incredibly difficult for investors to accurately assess unless they’re an expert in the area.” One way investors can assess a business’s credibility is through Companies House, Mr Yearsley suggests.
If investors choose to invest through pooling then, Mr Niblock explains “variable volatility in the market means investors usually get their interest rate if they lend collectively, to a number of borrowers”.
Orca Money allows for some defaults. Mr Niblock says: “It’s all about the expected default rate and if there were any variations above that then we would consider dropping the platform, but we wouldn’t go with a platform that had so much exposure to one borrower.” He says lenders who invest in a passive manner and distribute across a number of borrowers face only a low risk from individual borrowers defaulting, so the risk of losing money is reduced.
The FCA’s new game plan
In general, Ms Coles recommends investing no more than 10 per cent of your portfolio in P2P lending. “For investors who only want individual bonds then a good idea is to look at 10 bonds – so if you’re putting £2,500 in 10 ways, then you can reduce your risk and take in payment at different times,” Mr Yearsley explains. In fact, as of last week and following the recent string of collapses, the FCA has now released new rules aimed at better protecting P2P lenders.
Investors new to retail bonds and who have not received regulated financial advice are to be restricted to allocating no more than 10 per cent of their portfolio to P2P loans, to ensure they do not overexpose themselves to risk. Platforms must provide investors with a minimum amount of information about borrowers, and will have to be more transparent and explain the governance arrangements, risk assessment and risk management systems they have in place to deliver the high interest rates they promise. IF Isas will also be required to set out and strengthen plans for the wind-down of P2P platforms if they fail.
Laura Suter, personal finance analyst at investment platform AJ Bell, says: “Peer-to-peer platforms have been dealt a blow by the regulator. The industry argued this limit is arbitrary and hard to enforce, but the regulator is pressing ahead regardless. It will be interesting to see how investors have to calculate and declare their investable assets to ensure they don’t exceed the cap.”
Some platforms reacted positively. Ms Groves says: “It is this type of consistent regulation across the alternative finance industry that’s needed to encourage greater transparency and therefore better understanding among investors.”
IF Isa providers
|Name||Target return||Loan type||Auto diversification||Lender protection||Loan term||Minimum||Secondary market|
|Ablrate||10-15%||Business||Option available||Asset-backed||1 year - 6 years||£100||Yes|
|Abundance||1.50%||Business||Option available||Some asset-backed||Varies||£5||Yes|
|ArchOver||6-11%||Business||Option available||Asset-backed||3 months - 3 years||£1,000||No|
|Assetz Capital||4%||Business||Yes||Asset-backed||1-5 years||£1||Yes|
|Basset Gold||6.22-7.46%||Business||Yes||Asset-backed||3-5 years||£1,000||No|
|British Pearl||4.40%||Property||No||Asset-backed||3-5 years||£100||Yes|
|Crowd for Angels||9.00%||Business||No||Asset-backed||1-2 years||£25||Yes|
|Crowd Property||8%||Property||Yes||Asset-backed||6 months - 1 year||£500||No|
|Crowd2fund||8.70%||Business||Option available||No||1-5 years||£250||Yes|
|Crowdstacker||4-7.25%||Business||No||Own scheme||1 year - 3 years||£100||Yes|
|Downing||3-7%||Business||Own scheme||Own scheme||1-3 years||£100||No|
|Easy Money||7.28%||Property||Yes||Own scheme||3 months - 1 year||£10,000||Yes|
|Fluid bond||6%||Business||Yes||Asset-backed||3 years||£2,000||Yes|
|Folk2Folk||4.5-9%||All||No||Own scheme||1-5 years||£20,000||Yes|
|Funding Circle||4.5/4.7%||Business||Yes||Own scheme||6 months - 5 years||£1,000||Yes|
|Funding Secure||16%||Property||No||Asset-backed||6 months||£25||Yes|
|HNW Lending||6-15%||Property||Option available||Asset-backed||1 month - 3 years||£5,000||Yes|
|Kuflink||7%||Business||Option available||Asset-backed||5 years||£100||Yes|
|Landlord Invest||5-12%||Property||No||Asset-backed||10 months||£100||Yes|
|Lending Works||5-6.50%||Business||Yes||Own scheme||3-5 years||£100||Yes|
|Money & Co||7%||Business||No||Asset-backed||3-5 years||£100||Yes|
|Money Thing||13%||Property||No||Asset-backed||3 months - 5 years||£1,000||Yes|
|Octopus Choice||4%||Property||Yes||Asset-backed||1-5 years||£10||No|
|Orca||4-4.9%||All||No||Individual platform’s scheme||Varies||£100||Yes|
|Property Crowd||7-10%||Property||No||Asset-backed||4 months - 1 year||£1,000||No|
|Property Partner||9-10%||Property||Option available||Asset-backed||6 months - 2 years||£250||Yes|
|Proplend||5-12%||Property||Option available||Own scheme||Varies||£1,000||Yes|
|Ratesetter||4.80%||Business and property||Yes||Reserve fund||5 years||£10||Yes|
|Rebuilding Society||8%||Business||Option available||Own scheme||6 months - 5 years||£100||Yes|
|The House Crowd||7%||Property||Yes||Asset-backed||3 months - 12 years||£1,000||No|
|Triple Point Advancr||5.90%||Business||Yes||Asset-backed||1-3 years||£1,000||No|
|Welendus||5-15%||Personal||Yes||Reserve fund||1 month - 1 year||£100||Yes|