Since April 6, 2016, investors keen to shelter their returns from tax can choose to lend their money via peer-to-peer lenders instead of keeping it in cash or investing in stocks and shares.
So-called Innovative Finance ISAs are designed to help people cash in on the success of the peer-to-peer sector, which brings together savers looking for higher interest and individuals and businesses looking to borrow at reasonable rates.
So how do they work? Let’s find out.
What do Innovative Finance ISAs involve?
With Innovative Finance ISAs, the money you invest is lent out to companies or individuals at a set interest rate. Often this rate is fixed for a set term (typically a year or more), but some shorter term accounts offer variable rates.
The rate you receive depends on the risk profile of the person or business to which you offer the loan.
A company with a good credit profile, for example, might pay 4%, while an individual with an average credit rating might pay 6%.
The idea is to cut out the middleman – or in other words the banks – allowing both borrowers and lenders (savers) to benefit from better interest rates.
There are risks, however. Should the person or business you lend to default on the loan, you could lose some or all of your investment and your money won’t be protected by the Financial Services Compensation Scheme (more on this later).
How do they differ from traditional ISAs?
In the past, ISA investors had two choices: Cash ISAs that are essentially tax-efficient savings accounts, and stocks and shares ISAs that allow you to invest in assets such as shares, bonds and investment funds.
Innovative Finance ISAs, on the other hand, are solely for investing in peer-to-peer lending opportunities, with which you lend money to individuals or businesses who pay you interest on the loans.
Who will offer Innovative Finance ISAs?
The Financial Conduct Authority (FCA) has authorised eight peer-to-peer lenders to offer Innovative Finance ISAs.
Should something go wrong, investors with these companies could therefore complain to the Financial Ombudsman Service.
Authorised companies include Crowd2Fund and Crowdstacker.
However, many of the biggest players, such as Ratesetter, are among the 86 companies awaiting a decision.
How much can you invest in an Innovative Finance ISA?
There is a general limit on the amount you can pay into ISAs each tax year.
In the 2016/17 tax year, for example, you can invest up to £15,240 in total.
The amount can be split between different types of ISA, such as cash, stocks and shares and Innovative Finance accounts.
Alternatively, you can invest the full amount in just one type of account.
The maximum you can invest in an Innovative Finance ISA this tax year is therefore £15,240.
What are the tax advantages?
Much like other ISAs, with Innovative Finance ISAs, savers can put a tax-free “wrapper” around their investments and thus avoid paying tax on any of the interest they earn.
However, the benefits of ISAs are no longer quite so appealing. That’s because as of April 6, 2016, basic rate taxpayers can earn up to £1,000 tax-free interest a year in any savings account, including peer-to-peer and current accounts, while higher rate tax payers can earn up to £500 a year.
You can read more about this personal savings allowance here.
However, keep in mind that because interest rates on peer-to-peer investments tend to be higher, you’re more likely to reach your tax-free threshold, and therefore investing in an Innovative Finance ISA – where all your earnings are tax-free – can still be beneficial.
Any interest you earn in ISAs doesn’t count towards your personal savings allowance, so it’s worth using both options.
Are Innovative Finance ISAs safe?
The main thing to be aware of is that peer-to-peer investments do not qualify for the protection of the Financial Services Compensation Scheme, which guarantees the first £75,000 (or £150,000 for joint accounts) should a bank or building society go bust.
That means you could lose some or all of your original investment.
However, peer-to-peer lenders manage the risks by lending your money out to lots of different people so that even if one or two default it will not eat up all your cash.
They also often have compensation arrangements of their own to ensure you don't lose out.
Is there an Innovative Finance Junior ISA?
No. There are no plans at the moment to offer Innovative Finance ISAs for under-18s.
Peer-to-peer lending is regulated by the Financial Conduct Authority, but your money is NOT protected by the Financial Services Compensation Scheme. There is a risk you may lose some or all of your initial investment
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