Innovative finance ISAs are a particular type of tax-efficient savings account that use peer-to-peer lending to generate returns.
While this type of ISA has become less popular in recent years, a few banks, lenders and crowdfunding platforms still offer them.
Here, we explain everything you need to know about innovative finance ISAs (IFISAs), and the risks you should be aware of before investing in one.
What are innovative finance ISAs?
An individual savings account (ISA) enables you to tax-efficiently save or invest a certain amount of money each (£20,000 a year in the 2022/23 and 2023/24 tax years). ISAs are shielded from tax, meaning that any money you make from interest on your savings or investments are tax-free. You can read more about how ISAs work in our article Everything you need to know about ISAs.
Launched in 2016, innovative finance ISAs hold peer-to-peer loans instead of cash or investments. This essentially means that your money is being divided into small chunks and lent to hundreds of different individuals or small businesses in the hope of attractive returns. The process isn’t the same as being an investor or shareholder in the company, as you don’t own any part of the business – you simply benefit from the interest that the company or individual pays on the loan. You can generally choose how long you want the term of the loan to be, with lenders offering terms as short as one year and as long as 20 years.
You can learn more about how peer-to-peer lending works in our article Peer-to-peer lending – is it a good investment? The difference between standard peer-to-peer lending and investing in an innovative finance ISA is that you won’t pay any tax on your returns. You can also split your allowance between different types of ISAs so, for example, you could put some into an innovative finance account, and the rest into a cash ISA or stocks and shares ISA. You can only invest in one IFISA each tax year, however.
It’s worth noting that if you invest in peer-to-peer outside an IFISA, your interest will still be protected from tax up to a certain amount because of your personal savings allowance (PSA). This allowance lets basic-rate taxpayers earn up to £1,000 in interest each tax year free of tax, and higher-rate taxpayers can earn up to £500 (additional rate taxpayers don’t get an allowance).
What are the risks of innovative finance ISAs?
The biggest risk of peer-to-peer lending, and therefore innovative finance ISAs, is that borrowers may default on their loan and you won’t be repaid the full amount. While there is no guaranteed protection for your money if this happens, your IFISA provider may have a contingency fund that pays out compensation in this scenario. You should check if this is the case and see how much they are prepared to pay in this event before putting your money into a IFISA. You might also lose out on some interest if the borrower pays off some or all of their loan early.
If your IFISA provider goes bust, you may not get your money back. Cash ISAs are protected for up to £85,000 under the Financial Services Compensation Scheme, but forms of peer-to-peer lending – including innovative finance ISAs – are not, so you’re not guaranteed compensation if your provider goes under. Several peer-to-peer firms have folded since the introduction of IFISAs, so this is something to consider.
Additionally, it can be difficult offloading your loan if you decide you want to withdraw your money. This is because you will need to sell it to someone else, and the market for doing so might be fairly limited or non-existent.
What other kinds of ISA should I consider?
Even though innovative finance ISAs pay returns, they work very differently and are much riskier than a standard savings account. Even if the interest rates look attractive, you should be cautious and think about whether your money might be better off in another type of ISA that gives you greater control over where your money goes.
If you’re curious about cash ISAs and stocks and shares ISAs, our article Should I invest in a cash or a stocks and shares ISA? will help you learn more and choose the kind of account that suits you best.
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