The innovative finance ISA was introduced by the UK government on 6th April 2016. It allows UK individuals to lend their funds through peer-to-peer lending platforms and receive interest and capital gains tax free as it is in an ISA wrapper.
Peer-to-Peer lending is a new form of investing that has now been in the UK for around a decade that allows individuals that have available cash lend directly to business or other individuals who need to borrow money. It essentially cuts out the middle man function that banks perform when lending and borrowing money.
Traditionally, people with excess cash would deposit their money at the bank and receive an interest rate on this cash. The bank would then lend out this cash to individuals or businesses that wanted to borrow and charge them a rate of interest for it.
Compared to Banks
Rather than going through the banks, individuals who want to earn an interest rate on their excess cash can access a peer-to-peer lending platform and see a marketplace of individuals or businesses wanting to borrow money and the rate of interest they are willing to pay.
Peer-to-peer lending platforms typically have lower running costs than traditional banks, so they take less of a fee and the end result is normally that the lender receives a higher interest rate and the borrow pays a lower interest rate than they would if they had gone through a bank.
Within the UK those that have lent using peer-to-peer lending in the last decade have typically earned good returns, higher than most cash ISAs. This is the result of higher interest rates being offered and there not been a lot of defaults on the loans (defaults are people not paying their loans back).
There have not been many defaults as the economy has been performing well so businesses have mostly been able to pay back their loans. It will be interesting to see how peer-to-peer lending performs in an environment when the economy is not performing as well as it has been in recent years.
Peer-to-peer lending is regulated by the FCA but it is not covered by the Financial Services Compensation Schemes (FSCS). The FSCS acts as compensation fund of last resort for customers of most banks and building societies for the first £75,000 in savings that hey hold with that bank or building society. So, if the bank were to go bankrupt then the government would pay you out up to £75,000 of your saving in that bank. Whilst peer-to-peer lending platforms are not covered by this scheme, some of the platforms do have a reserve fund to pay out to lenders if a borrower does default. These funds have not yet been tested yet in a poor economic environment.
When investing peer-to-peer it is best practices to lend small amounts of your money to a lot of borrowers rather than lending all your money to one borrow. For example, if you had £1,000 it would typically be better from a risk management perspective to lent £10 to a hundred borrowers rather that £1,000 to one borrower. This way if one borrower defaults you don’t lose all your money, only a small part of it.
Whilst diversifying your lending like this helps reduce risk of any one company defaulting affecting your overall returns, it must be noted that if all the companies you have lent to are in the UK, you are still at risk to the UK economy as a whole performing badly. This could lead to many companies defaulting.
There are many different types of peer-to-peer lending platforms. In some of them you deposit your money for a set rate of interest and then your funds are automatically lent out too many different borrows. This is similar to how banks operate. With some other platforms however, you get to decide who to lend your money too. This has both its advantages and disadvantages. It is a good thing for those who have time and the skills to identify who they think are credit worthy borrows, and some people may enjoy deciding who they lend to. But for some others this may be a disadvantage as they do not have the time or skills to do so. Most platforms do however give their own assessment of how credit worthy they think the borrower is.
Access of funds
Another thing to note with peer-to-peer lending is how easy or hard it is to access your funds if you need to withdraw them. With some platforms you may be able to withdraw your funds at any time free of charge. Other platforms you may have to pay a fee for this service or wait for a certain period. In some platforms however, you must commit your funds for the full terms of the loan.
So, for example if you lend £1,000 to a company for 5 years it will take the full 5 years to get the initial £1,000 back and interest along the way of course. You might receive £100 every 6 months along with the interest payment. On some platforms you may be able to sell your loan to another person who wants to buy it.
To summarise like most investments there are advantages and disadvantage to using an innovative finance ISA for peer-to-peer lending. The main advantage is that they can offer a good return on your cash that will typically be higher than most cash ISAs will offer, and this interest will be tax free. Peer-to-peer lending can also be a good diversifier if used as a small part of a larger portfolio of investments as it is seen by some as a new asset class. Some people may find it enjoyable to be able to decide who to lend their money too.
The main disadvantages are that it may require more time and expertise than investing in a cash ISA or a stocks and shares ISA that is managed for you. It might also be hard to withdraw your funds if you need to on short-notice. There are many different types of peer-to-peer lending platforms, so it is important to understand how they operate if deciding on one. Whilst the returns for peer-to-peer lending have been good in UK in the last decade they have not been tested in an especially weak economic environment. Also, remember peer-to-peer lending is not covered by the FSCS. It is also worth remembering if all the companies you are lending to are situated in the UK you are particularly dependent on the UK economy performing well.
Photo - Mikael Kristenson