How has the Innovative Finance Isa evolved as an option for both experienced investors seeking to diversify and newcomers stepping up from cash?
Innovative Finance Isas (IF Isas) were launched in April 2016, providing investors with a halfway house between the low-risk, minimal return cash Isa arena and the stock market risk of stocks and shares Isas – but they got off to a slow start. So what sort of choice is now available, and what risks and attractions are attached to these products?
The Innovative Finance Isa continues to evolve as an option for both experienced investors seeking to diversify and newcomers who would like to step up from cash and its lacklustre returns. For investors who are willing to take risks by lending via peer-to-peer platforms, IF Isas offer returns of between 3 and 8 per cent a year depending on the risk level – markedly higher than the returns available through cash Isas. The Isa wrapper then shelters these returns from the taxman.
With peer-to-peer (P2P) products, an investor lends money to borrowers, who pay back the loan plus interest over fixed terms of between one and five years.
The transaction is conducted on an online platform. The first P2P lending platform was Zopa, which launched in 2005. Some platforms only lend to individuals, while others focus on small businesses or lend to both. Certain platforms focus on property opportunities, enabling investors to lend money to people who are looking for a buy-to-let mortgage, or to invest in a property that’s being developed or refurbished. Anyone can become a lender, for as little as £10.
As with other innovations in financial technology, P2P lending is premised on cutting out the middleman – in this case high street banks – to reduce costs. In contrast to banks, P2P lenders are not subject to capital requirements and they do not have physical branches, which is why they can afford to offer much more competitive rates to borrowers as well as lenders.
In many cases, no income tax is due on gains from P2P because of the personal savings allowance (PSA), which means basic-rate taxpayers can receive up to £1,000 of interest tax-free (£500 for higher-rate taxpayers). To put that into context, it would be possible for a basic-rate taxpayer to invest up to £20,000 in a loan paying 5 per cent a year, and remain within the PSA. However, higher- rate taxpayers, and those looking to invest larger sums or seeking higher interest rates, are likely to benefit from the use of an Isa wrapper.
The IF Isa reflects the UK government’s desire to encourage new sources of individual and small business financing, due in large part to the banks’ reticence in lending to these segments of the economy following the 2008 financial crisis. Moreover, rock-bottom rates offered on cash deposit accounts over the past decade have played a key role in the growth of the P2P industry.
Where do the risks lie?
Critics argue that P2P lending has yet to pass the test of time. Famously, Lord Turner, the former boss of the then Financial Services Authority (now the Financial Conduct Authority) argued in 2016 that in the next five to 10 years there would be huge losses for peer-to-peer lending platforms, which would make the banks look like ‘lending geniuses’.
So far this fear has not materialised. However, there are clear risks attached to peer-to-peer lending. First, if the borrower cannot repay, in theory the lender could lose that money. In practice, P2P platforms have differing security set-ups to protect lenders. Some have contingency funds to protect investors from loan defaults. Others say they reduce risk for investors by spreading everyone’s capital across many different borrowers. It’s crucial to enquire as to the kind of contingency funds and buffers a platform has in place.
Secondly, unlike deposit accounts, where the Financial Services Compensation Scheme (FSCS) reimburses savers’ losses up to £85,000 should a provider go bust, P2P investments are not protected in the event that the platform defaults.
So far, no platform has actually gone bust, but a rapidly growing industry makes it more likely to happen in the future, as the quality of loans will inevitably vary and a recession would stress-test the industry.
Some platforms have already had to take action to protect customers’ money. In 2017, RateSetter dipped into its own funds to ensure its 50,000 investors were not hit by struggling borrowers. There were also concerns in 2017 that Lendy Finance’s level of defaults was too high.
Would-be investors should look at expected and actual default rates on loans from the platforms they are considering using. Zopa, for example, had an expected default rate of 4.52 per cent in 2017, while 0.86 per cent of its loans actually defaulted. It’s worth noting that the company has been gradually increasing its expected default rates over the last 12 years, but the highest level of actual loan defaults (4.2 per cent) happened in 2008, the year of the financial crisis.
Before peer-to-peer lenders can offer the tax shelter of an Isa, they have to be authorised by the FCA and HM Revenue & Customs, but a surge of applications has led to big hold-ups in the authorisation process. At the time of writing the FCA has approved 82 peer-to-peer, investment and crowdfunding platforms to offer an IF Isa, including Crowdstacker, Crowd2Fund and Zopa. But while the market seems to be growing, it has not taken off yet. According to HMRC figures, only 2,000 IF Isa accounts were opened in the 2016/17 tax year.
In contrast, there is a total of 2.6 million stocks and shares Isa accounts and 8.5 million cash Isas in existence.
However, many providers were only authorised to open their IF Isas for this tax year. For example, major P2P lender RateSetter launched its IF Isa in February this year, and the lender says that almost 10,000 investors have subscribed well over £75 million in it, at an average interest rate of 4.4 per cent per year.
Stuart Law, chief executive of Assetz Capital, says: ‘IF Isa take-up was slow in the first year of launch, but that was because most of the major players hadn’t launched an offering. There were only 2,000 accounts opened across the whole industry in the 2016/17 tax year, whereas we’ve had nearly 3,000 opened in just over five months.’
He argues that the market will grow further as peer-to-peer investment becomes more mainstream. He adds: ‘With bank interest rates remaining low, the average cash Isa is really losing its appeal as more and more people turn to alternative finance. We’re likely to see an increase in people voting with their feet and moving away from legacy Isas in the years to come.’ He also argues that there needs to be a simplification of the Isa wrapper, because with so many variants, including the IF Isa, cash Isa, stocks and shares Isas, lifetime Isa, help-to-buy Isa and junior Isa, there is the potential for confusion.
Working your capital
John Goodall, chief executive and co-founder of buy-to-let specialist Landbay, emphasises that the IF Isa allows investors to put their money behind something that they may not have the capital to back outright. ‘For example, the underlying fundamentals of the property market are supportive of strong returns, but the sector is hard to access for those who can’t afford to buy a property,’ he explains.
In addition, investors have the freedom to choose who they want to lend to. ‘Whether it be to small and medium-sized enterprises or UK landlords, the peer-to-peer mechanism allows investors to put their assets in a variety of asset classes, with risk levels depending on the asset classes they invest in,’ says Goodall.
Some of the IF Isa providers have an ethical or a heritage-related slant. Abundance, for example, is a peer-to-peer ethical investment platform, which gives people access to the social and affordable housing sector, and to renewable energy and energy efficiency projects. Meanwhile, alternative investment fund manager Oaksmore has a two- or five-year bond (paying 5 and 7.5 per cent respectively) that can be held in an IF Isa. The bonds allow people to invest in a range of traditional buildings ‘of national or regional importance’ in the UK that have fallen into disuse and are being restored.
Reuben Skelton from Oaksmore says the Oaksmore Isa ‘is 100 per cent property-backed, so the investors are protected by having their money charged legally against underlying property. He adds: ‘This is an enhancement over a stocks and shares Isa, for example, where the value of the underlying investment – shares – is worthless if that company enters insolvency. In the event of a problem we can either sell the land or instruct another developer to continue with the project.’
Jonathan Rogers, a partner at law firm Taylor Wessing, expects the IF Isa to become more popular now that the big P2P players are offering the product. ‘Despite the absence of an anticipated FCA review of the P2P sector, the bellwether for the IF Isa looks good as it matures and makes its way into public consciousness,’ he says. But he cautions that increased inflows will not be without risks for P2P platforms, ‘and as operations are scaled up to meet demand, firms would be wise to review and enhance their risk governance models’.