Updated 23 March 2022
The innovative finance ISA is one of a number of different types of ISA available to savers – the other broad categories being cash and stocks & shares, and the subcategory of 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 an asset called peer-to-peer (P2P) loans. Here’s what you need to know about these loans, from the benefits to the risks, and how holding them inside an ISA wrapper can be more tax-efficient.
An innovative finance ISA (IFISA) is essentially a tax wrapper around one or more P2P loans. The ISA tax wrapper means that 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).
P2P lending has become popular in recent years as a way for savers to earn more interest than they can from low-interest cash accounts. Various platforms such as Ratesetter and Zopa 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. Superficially these platforms may resemble savings accounts, but it’s important to be aware that the risk is much greater than with a cash account (see below). That said, the major UK-based providers have to date shown a good track record in protecting savers’ money.
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 & 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. He 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, all of 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 £300. So using an IFISA has saved him £200 for the year.
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 £80,000 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 rate of interest, 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 to be very small, since the most reputable providers have large reserve funds to protect their investors from defaulting debtors. However, in times of financial turmoil it may be that large numbers of debtors fail to repay their loans – which could place those reserve funds under strain.
Broadly speaking, P2P loans and IFISAs should be considered higher up the risk spectrum than cash or most bonds, but not quite as high as stocks & shares. But bear in mind that higher risk usually means higher potential returns. Ultimately, the choice hinges on your own resilience to risk, i.e. how much you can afford to lose if things go wrong.
The IFISA with the highest ‘target returns’ currently offer up to 8% to 10% interest, though most are much lower than this; Ratesetter’s most ambitious IFISA offers 4%, but rates of 5% to 6% are not uncommon. 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.
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 only pay into IFISA in each tax year, though you can hold several concurrently provided you’re only paying into one per tax year.
Money can be transferred between ISAs without affecting your annual ISA allowance, so you are free to transfer any money that is already held in either a cash or stocks & shares ISA into your IFISA. However, you can only transfer the full amount, 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 & shares ISA, this means that all the 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 first 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.
Currently there is no option to transfer any existing P2P loans into an IFISA. If your investment is small enough that you’ll make less interest than your personal allowance, you may not need an IFISA at all. 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 interests to hang on to your current investments until the best time to offload them.
The world of IFISAs is still young, and the sector is filled with new market entrants. Here are some names to research and discuss with your independent financial adviser: