The innovative finance ISA is one of many types of ISAs available to savers.

The other ISAs include cash and stocks and shares, the Lifetime ISA (and the no-longer available Help to Buy ISA).

Rather than cash or equities, the innovative finance ISA allows tax-free investment in peer-to-peer (P2P) loans.

Here’s what you need to know about these loans, from the benefits to the risks, andhow holding them inside an ISA wrapper can be more tax-efficient.

What is an innovative finance ISA?

An innovative finance ISA (IFISA) is essentially a tax wrapper for one or more P2P loans.

Holding these in an ISA means any growth on the investment is not subject to the taxes (e.g. capital gains tax or income tax) that would normally be paid on the growth or interest.

This allows you potentially to make more money from investing in these assets than you otherwise would (all else being equal).

What are P2P loans?

P2P lending has become popular in recent years as a way for savers to earn more interest than they can from cash accounts.

Various platforms offer consumers the ability to put up their money as loans to small businesses and individuals, earning a rate of interest over time as the money is (hopefully) paid back.

These platforms may resemble savings accounts, but it’s important to be aware that the risk is much greater than with a cash account.

How does an innovative finance ISA work?

When you open an IFISA, it forms part of your overall ISA allowance for that year – currently £20,000.

This means you can invest up to £20,000 in any combination of cash, stocks and shares or innovative finance ISAs.

Opening an IFISA means that up to £20,000 worth of P2P loans can be held in the ISA tax wrapper, so you won’t pay any tax on the interest earned.

Interest from P2P loans forms part of your annual personal savings allowance (£1,000 of interest for basic rate taxpayers, £500 for higher rate taxpayers), so you’ll only be liable for tax on larger investments.

Here’s an example of how it works in practice:

Ed has £50,000 to invest and decides to invest it all in P2P loans. First he uses his full ISA allowance, and then places the remaining £30,000 in other P2P loans outside an ISA. All his loans pay a 5% rate of interest.

His £30,000 of non-ISA loans earn a total of £1,500 of interest. Of this, £500 is taxable at his basic rate of 20%, so Ed pays £100 in tax – bringing his net gain to £1,400. Meanwhile his ISA earns £1,000 of interest, which he gets to keep.

However, if Ed had invested the whole £50,000 in P2P loans outside of an ISA, his total tax bill would have been higher. 

What are the risks of an innovative finance ISA?

It bears repeating that an IFISA is not a cash savings account, even if it may resemble one.

Cash savings accounts are protected by the Financial Services Compensation Scheme (FSCS), so up to £85,000 per provider is protected if your provider collapses. This protection doesn’t apply to P2P loans or IFISAs.

Similarly, although P2P loans quote interest rates as if they were savings accounts, this interest rate is not guaranteed.

There remains the possibility that the debtor at the other end will not be able to repay the loan in full.

This could mean you don’t earn the promised interest rate, lose some of your original investment or even all your investment.

The risk of this happening with one of the major P2P platforms is currently considered small since the most reputable providers have large reserve funds to protect their investors from defaulting debtors.

However, in times of financial turmoil, large numbers of debtors may fail to repay their loans, which could strain those reserve funds.

P2P loans and IFISAs should be considered higher up the risk spectrum than cash or most bonds, but not quite as high as stocks and shares.

But bear in mind that higher risk usually means higher potential returns. Ultimately, the choice hinges on your resilience to risk, i.e. how much you can afford to lose if things go wrong.

What kind of returns can I expect from an innovative finance ISA?

The IFISA with the highest ‘target returns’ currently offer up to 8% interest, though some are lower than this.

The key phrase is ‘target returns’ – the provider will aim to offer this level of interest, but it is not guaranteed.

Also, as a rule of thumb, the higher the target returns, the more your capital is at risk.

The level of access you have to your funds will also depend on the provider. Usually, you can withdraw your funds as long as they are not being used by a company, though there can be a waiting period of 30 to 90 days.

Some IFISAs also have fees or penalties for withdrawing money earlier than agreed.

Can I have an IFISA as well as another kind of ISA?  

You can hold an IFISA alongside other ISAs, provided the total you invest in one tax year does not exceed £20,000.

Furthermore, you can now open and invest in multiple ISAs of the same type. 

Can I transfer from my other ISAs into my IFISA?

Money can be transferred between ISAs without affecting your annual ISA allowance, so you can transfer any money already held in either a cash or stocks and shares ISA into your IFISA.

However, you can only transfer the full amount from the current tax year, not a part of it, so think carefully before making the decision.

Your IFISA provider can handle the process for you – you just need to fill out a transfer form.

If you’re transferring from a stocks and shares ISA, all equities held in that ISA will first be sold to convert them into cash.

You should therefore make sure it is a good time to sell them, i.e. not right after a market crash.

It is important that you don’t withdraw the money and transfer it manually. This will count against your ISA allowance for that year, reducing your ability to invest other money in ISAs.

Even worse, if you have more than £20,000 to transfer and you withdraw it, you’ll only be able to reinvest £20,000 in that year, exposing the rest to tax.

When considering transferring into an IFISA, think about your asset allocation and whether your investments overall carry the right balance of risk for you.

You shouldn’t expose all of your wealth to high risk assets.

Can I transfer existing peer-to-peer loans into an ISA?

Currently, there is no option to transfer any existing P2P loans into an IFISA.

If your investment is small enough to make less interest than your personal allowance, you may not need an IFISA.

But if you are investing a lot or plan to do so in the near future, you may be better off cashing in your current loans and taking out a new IFISA.

However, this is a decision to be made carefully, as it may still be in your best interests to hang on to your current investments until the best time to offload them.

Who offers innovative finance ISAs?

The world of IFISAs is still young, and the sector is filled with new market entrants.

Here are some names of innovative finance ISA providers to research and discuss with your independent financial adviser:

• Kuflink
• CrowdProperty
• Triodos Bank 

If you found this article useful, you might also find our article detailing what a flexible ISA is informative, too.