Peer-to-peer Isa: a beginner's guide
Innovative Finance Isas (IF Isas) were introduced in April 2016, and attracted attention as a tax-free route into the peer-to-peer lending (P2P) and other alternative lending opportunities offering markedly higher returns than those available through cash Isas.
We look at the attractions and drawbacks of IF Isas (including the risks and typical returns), the limited products available and the kind of returns they offer.
In P2P lending, an investor lends money to borrowers who pay interest and return the capital at the end of the term. The exchange is made through online platforms. Some platforms only lend to individuals, while others lend to small businesses or both.
HALFWAY HOUSE BETWEEN SAVING AND INVESTING
Like many other innovations in the financial sector, P2P lending is premised on cutting out the middleman, which in this case is the high street bank.
In contrast to banks, P2P lenders are not subject to capital funding requirements and do not have physical branches, which is why they can afford to offer highly competitive rates to both borrowers and lenders.
Anyone can become a lender with as little as £10. Across all their Isas, investors are able to put in up to £15,240 in the 2016/17 tax year, and this will increase to £20,000 from April 2017.
Unlike deposit accounts, P2P investments are not protected by the Financial Services Compensation Scheme (which will reimburse savers' losses up to £75,000 should a bank go bust).
If an individual borrower cannot repay their loan, therefore, those who have lent to them will, in theory, lose their money.
Given the added risks of default (of the P2P platform or an individual borrower), money put into an IF Isa looks more like investing than saving.
'They are a half-way house between a cash Isa, which is safe but currently offering a very low return, and a stocks and shares Isa, which is more racy and where you carry more risk,' says Christine Farnish, chair of the P2P Finance Association.
The introduction of the IF Isa reflects the UK government's desire to encourage and support new sources of individual and small business financing, due in large part to the banks' reticence to lend to these segments of the economy in the aftermath of the financial crisis.
Concurrently, the abysmal rates offered on cash deposit accounts over the past seven years, due to the Bank of England's quantitative easing and ultra-low interest rate policies, have also played a key role in the growth of the P2P industry.
Critics argue that P2P lending has never really been tested, given that most of it has appeared since the financial crisis.
Lord Turner, the former boss of the then Financial Services Authority (now the Financial Conduct Authority, FCA), forecast in February that over the next five to 10 years there would be huge losses for P2P lending platforms that would make the banks look like 'lending geniuses'.
However, it is important to remember that some platforms are more transparent than others, and that P2P platforms have different levels of security.
Some have contingency funds to protect investors from loan defaults. Others say they reduce risk for investors by spreading their capital across different borrowers.
Before P2P lenders can offer IF Isas, they have to be authorised by the FCA and HMRC, but a surge of applications has led to long delays in the authorisation process.
At the time of writing, the FCA has given 12 P2P investment and crowdfunding platforms approval to provide IF Isas: Abundance Investment, Blackfinch Investment, Crowd2Fund, Crowdcube Capital, Crowd for Angels, Crowdstacker Limited, Greyfriars Asset Management, Link Financial Outsourcing, London House Exchange, Peregrine Asset Management, Resolution Compliance and Strand Capital.
But the big names, including Zopa, Ratesetter and Funding Circle, are still waiting. Peter Behrens, chief commercial officer and co-founder at RateSetter, says: 'To launch an IF Isa, platforms must first obtain full authorisation from the FCA.
'Currently, like all other major P2P lending platforms, we are fully regulated on an interim basis, and we're working with the FCA to become fully authorised as soon as possible.'
Jake Wombwell-Povey, chief executive at P2P platform Goji, says: 'There is no doubt the delay has taken some of the bang out of the IF Isa, as platforms will now likely launch during typically quiet Isa periods, so it will be mainly existing investors who benefit.'
The brakes that have been put on IF Isa rollout by the FCA's delays are justified, says Angus Dent, chief executive at P2P business lending platform ArchOver, because P2P 'is a broad church and those used to simply shopping around for the highest return on their savings may well get bitten'.
He adds: 'This is not like a move from, say, Nationwide to Yorkshire Building Society because the latter is offering a quarter point more.
'This is buying a fundamentally different service, which you need to take time to understand. I fear too many Isa holders won't put that time in and will buy unsuitable services.'
Another potential problem with IF Isas, he says, is that HMRC legislation stipulates that only P2P lenders will be able to offer them, which means investors will only have access to the individual loan book of a single lender (in contrast to stocks and shares Isas, which can be opened via fund platforms that enable investors to spread their investments across a very wide range of funds from different managers).
For investors to be able to spread their P2P IF Isa investment across multiple lenders, a third-party platform or broker (such as Interactive Investor) would have to become the Isa manager, but this has not happened so far.
'This means investors are limited to investing through one P2P lender in any given year. The potential for diversification is therefore limited to the opportunities available through a single lender,' says Dent.
PROS AND CONS
Dent has mixed feelings about IF Isas. He says: 'On the positive side, it gives access to P2P and a potentially higher return for savers.
'That's got to be a good thing, as most cash Isas pay next to nothing. On the other hand, the middle word of "individual savings account" is "savings", and we don't offer a savings product.'
Crowd2Fund is one of the platforms that has already received IF Isa approval. Its IF Isa offers returns estimated at 8.7 per cent a year on average.
Parteek Patel, chief executive at Crowdstacker, another authorised platform, says that since the introduction of the IF Isa at the start of this tax year, roughly 77p of every £1 invested through the platform has been via the tax wrapper.
With interest rates at historic lows, savers are venturing out into new territory to generate returns.
Abundance Investment is another platform that has already been authorised for the IF Isa. It specialises in renewable and ethical P2P loans.
Bruce Davis, founder and managing director, says: 'Abundance projects pay annual returns of between 6 and 9 per cent over the life of the investment (capital and income are returned in instalments), so investor returns cannot be generalised.
'However, we publish regular financial and business performance figures for all our projects, and over the first four years of investing we have seen projects overall on or slightly above target returns.'
Davis is hopeful that legislation enabling debentures - a type of bond - to be included in IF Isas will be enacted by 1 November, when his platform will open two new projects to investors (a solar and a wind power project).
It is currently unclear whether Isa investors will eventually be allowed to put cash into equity-based crowdfunding too. Many questions are yet to be answered and details to be confirmed - the IF Isa is only beginning to take shape.
EQUITY CROWDFUNDING: NOT AN IF ISA OPTION
The Treasury has introduced new legislation to allow IF Isas to incorporate 'crowd bonds' from 1 November 2016.
Crowd bonds are a type of crowdfunding debt, but unlike P2P lending and mini-bonds (other types of crowdfunding debt), crowd bonds allow investors to lend to UK businesses via bonds secured against a firm's operational assets.
This makes them arguably lower risk than unsecured loans, says Julia Groves, head of crowdfunding at Downing Crowd.
Only bonds and loans are allowed in the IF Isa. Equity crowdfunding, while fully regulated by the FCA, is not currently eligible for an IF Isa.
This is because businesses in equity crowdfunding are at much earlier stages and are normally not in a position to pay returns immediately, much less offer security, according to Groves.
Charles Owen, founder of CoInvestor, says the statistical failure rate among these companies is very high, which makes equity investment extremely high risk.
This risk is compounded when the platforms themselves are the ones conducting due diligence on the products they are selling.
Moreover, Owen adds: 'The majority of investments made via equity funding platforms benefit from substantial tax reliefs in the form of enterprise investment schemes. To put these inside a further tax wrapper in the form of an Isa would seem overly generous.'