Are Ifisas worth the risk?

The advantage of holding debt-based investments such as these in an Isa is that you can receive the interest payments they make without incurring income tax, and sell them without incurring capital gains tax. 

The main attraction of investing in this kind of debt is the high rates of interest it can pay. The platforms that provide it are currently advertising annual returns of anything between about 3 per cent and 15 per cent, although typically the higher the rate the higher the risk. 

You don't have to put your entire annual Isa allowance, which is currently £20,000, into an Ifisa. You could put some money into one of these and the rest into other types of Isas, for example cash Isa and stocks-and-shares Isas. You can also transfer an existing cash or stocks-and-shares Isa into an Ifisa. But in-specie transfers from a stocks-and-shares Isa into an Ifisa are not possible, so you would have to sell your investments and transfer the proceeds as cash into an Ifisa. 

"By investing in an Ifisa, people can benefit from high interest rates and receive their interest tax-free," says Patrick Connolly, certified financial planner at Chase de Vere. "This could be a significant benefit in a low interest rate environment, especially for those who have already used up their personal savings allowance."

The personal savings allowance is currently £1,000 a year for basic-rate taxpayers and £500 a year for higher-rate taxpayers. Additional-rate taxpayers who pay 45 per cent income tax don't have a personal savings allowance.

"The perennial search for income could be satisfied with P2P loans or debt-based securities," says Julia Groves, partner and head of crowdfunding at Downing. "Their returns – often of around 6 per cent a year – are tax-free within the Ifisa wrapper."

Examples of returns you can get from innovative finance Isas

Source: providers

Risks

Ifisas could help you to diversify away from listed bond and equity markets. But Ben Yearsley, director at Shore Financial Planning, says you need to understand what you are investing in as the types of investments you can hold within an Ifisa can be fairly different from each other.

"It's not like a cash Isa, whereby the manner in which returns are produced is the same, and the only main difference is the interest rates," he explains. "It's also different to investing in funds on a platform such as Hargreaves Lansdown or Charles Stanley, because you've got to assess the platform providing the Ifisa and their offer separately, as each provider will have its own dealflow and own unique offers as well."

Platforms often provide loans to specific types of borrowers, such as individuals, companies or property developers, or in some cases such as RateSetter, to more than one type of borrower. Some platforms automatically spread your investment across a range of loans, while others allow you to manually choose which loans you would like to invest in. Platforms typically originate the debt you hold within their Ifisas and use their own methods to screen applicants for loans.

"But [screening] will often be to assess whether the platform is happy with the threat of default the borrower poses – rather than to screen out risks altogether," says Sarah Coles, personal finance analyst at Hargreaves Lansdown.

So it is important to consider the Ifisa as a potentially high-risk investment rather than something like cash savings, because of the risks of borrower defaults.

P2P loans are not protected by the Financial Services Compensation Scheme (FSCS), unlike cash or regulated investments such as unit trusts and open-ended investment companies offered by UK authorised firms. With cash deposits the FSCS pays out £85,000 per person per firm for claims against firms declared in default from 30 January 2017. And with regulated investments, for example corporate bond funds, the FSCS covers up to £50,000 per person per firm for claims against firms declared in default from 1 January 2010.

Some independent financial advisers are not keen to put their clients' money into the types of investments you can hold within an Ifisa because they are not covered by the FSCS. If the platform originating the loans goes under you will rely on its recovery procedures, and your loans may not be repaid.

"For us to consider investing [in Ifisas] we would have to understand and be comfortable with how these investments perform in more challenging environments, and have a wide range of investment options protected by the FSCS," says Mr Connolly.

Dealing with defaults

If the economy deteriorates, borrower default rates could rise, increasing the risk of lenders losing money. However, platforms aim to mitigate the risk of borrower default in a number of ways. Platforms including Assetz Capital, Landbay, Lending Works and RateSetter offer a provision or contingency fund – a pot of money that can be used to compensate lenders when borrowers default.

Some platforms, such as Crowdstacker, Downing and LendingCrowd, only originate loans secured against an underlying asset such as property. If a borrower defaults, the asset against which their loan is secured can be sold to recoup all or part of the lender's money.

Some large platforms including Funding Circle do not secure loans or have contingency funds, but aim to mitigate risk by diversifying lenders' money across a basket of loans, so that if a few default, investors will not be left out of pocket.

But Ms Coles says: "Some platforms draw attention to the fact that no investor has yet lost any money. However, the whole market is relatively young and has yet to experience a high interest rate recession, which would test the platforms' ability to mitigate higher default rates."

Platforms also have different ways of calculating what counts as a borrower default, making it difficult to compare their delinquency rates. Lenders that are members of the Peer to Peer Finance Association (P2PFA) use its default standard to provide comparable statistics for their default rates. The P2PFA defines a default as any portion of a loan that has not been repaid 120 days following the original loan repayment date, or where the borrower is not going to repay the loan for reasons such as bankruptcy. This definition also includes all the costs incurred in relation to late repayments, which are not recovered in full from the borrower. Members of the P2PFA include Crowdstacker, Folk 2 Folk, Funding Circle, Landbay, Lendinvest and Zopa.

Research service Orca, meanwhile, analyses major platforms' loan books on a monthly basis to produce standardised metrics on defaults.

If you lend via one of these platforms you may not be able to get your money back before the full duration of the loan's term. However, some provide a secondary market where lenders can sell their loans to other investors, usually for a fee. And some platforms use their balance sheets to facilitate investor withdrawals.

Availability can also be a problem. For example, Zopa was forced to close to new money at various points during 2017 as it struggled to match soaring demand from lenders to suitable borrowers. Investors who want to lend via Zopa are currently being put on a waiting list, although the company says they typically only spend a week on it.

Because of these risks, if you are thinking of opening an Ifisa make sure the platform you are considering is authorised by the FCA (see below).

"This is a relatively new market, so you need to be sure you understand exactly how and where your money is being lent, the risks involved, and how your provider mitigates those risks," says Ms Coles. "It's also worth considering whether the Ifisa offers a balance of risk and reward you are comfortable to take on."

Authorised innovative finance Isa providers

Source: HMRC, as at 9 March 2018