The risky new Isa offering 9% returns: what you need to know about peer-to-peer Isas
A new tax-free savings scheme joins the Isa family this year. The Innovative Finance Isa (IF Isa) is promising bumper tax-free returns of up to 9% a year. But although it may look like a savings account, it carries a lot more risk than a cash Isa.
How peer-to-peer lending works
IF Isas are designed to allow you to make tax- free returns on your savings from peer-to-peer investing. This is where you lend your money directly to individuals and small businesses via a peer-to- peer platform.
Traditionally, when you put your money in a bank, the bank uses it to fund loans. By cutting out the middleman – the bank – and by operating online with low overheads, peer-to-peer lenders can provide the service more cheaply.
This means peer-to-peer investing offers higher returns than you can get in a traditional savings account. It’s possible to earn 9% a year over five years with peer-to- peer, compared to just 3% a year from the best five-year savings account (at the time of writing).
Those higher returns mean peer-to-peer is an exploding financial sector. It has doubled in size in the past year alone.
“Peer-to-peer lending is proving increasingly popular as investors are attracted by the prospect of returns that are significantly better than those available on savings accounts,” says Patrick Connolly, a certified financial planner at Chase de Vere.
“However, it would be a mistake to directly compare peer-to-peer lending with bank and building society accounts because the risks are higher.”
How the new Isa works
IF Isas will work just like a standard peer-to-peer account, except that the money you make will be free from income tax. You will be able to invest your full annual Isa allowance of £15,240 into an IF Isa.
RateSetter has been the first peer-to-peer lender to announce details of its IF Isas. It will offer four different IF Isas ranging from a one-month term paying 2.8% to a five-year term paying 5.7%. The interest rates aren’t set in stone yet as peer-to-peer returns fluctuate depending on demand for loans but these are the expected rates.
In contrast, the best one-month notice cash Isa pays 1.5% and the best five-year cash Isa offers a 2.6% interest rate (at the time of writing).
“The Innovative Finance Isa is a refreshing new opportunity for British savers and investors looking for higher returns than cash Isas but less volatility and risk than equities,” says Bruce Davis, co-founder and managing director of peer-to-peer firm Abundance.
A survey by peer-to-peer company ThinCats found that one in four investors over the age of 55 is considering putting money into an IF Isa.
Each year you can put new money intoo a maximum of one stocks and shares Isa, one cash Isa and one IF Isa.
What are the risks?
Putting your money into a peer-to-peer account carries more risk than if you put it in a standard savings account. Firstly, you run the risk of your borrowers not repaying.
However, peer-to-peer providers reduce this risk by spreading your money across numerous loans so if one borrower defaults, you won’t lose all your savings. Also, some peer-to-peer providers, including Zopa and Ratesetter, have funds set aside to pay out if a lender defaults so you don’t lose out.
“It is in the interests of peer-to-peer providers to keep lenders money safe and secure. If losses incurred are too great and it impacts lenders, then word will soon spread and people will lose confidence in the peer-to-peer sector as a whole,” says independent personal finance analyst Andrew Hagger.
“Peer-to-peer sits somewhere between cash savings and stock market investing – not 100% safe like cash but not as volatile as stock markets. Potential returns are attractive and even more so when tax-free via an IF Isa,” says Mr Hagger.
However, just because the familiar, trusted Isa name has been put to these accounts doesn’t mean they are any less risky than normal peer-to-peer investing. In order to offer IF Isas, a peer-to-peer company must be regulated by the Financial Conduct Authority, but they still won’t be covered by the FSCS.
Peer-to-peer lending has been around for over a decade now and, as yet, no British company has gone bust. But only Zopa existed during the last financial crisis, so many fear the companies haven’t really been tested yet.
One person who thinks IF Isas and peer-to-peer lending could prove dangerous is former City regulator Lord Adair Turner. He recently told the BBC’s Today programme that he believes we’re heading for a peer-to-peer crash.
“The losses on peer-to-peer lending which will emerge within the next five to 10 years will make the worst bankers look like absolute lending geniuses,” he said.
He warned that many of the people taking out peer-to-peer loans have been rejected by traditional lenders which makes them higher risk.
It’s an accusation that has been rejected by peer-to-peer companies.
“It’s a pernicious assumption that our lending is just for the bank rejects,” Rhydian Lewis, RateSetter’s chief executive, says. “It’s convenient for the banks to say that, but we’re now beyond that and definitely competing for borrowers with the banks – in many situations offering borrowers better deals.
“When it comes to small business lending, we talk to borrowers and make sure we get all the information we need from them.
“We visit a lot more businesses than most banks would consider worthwhile visiting, so it is a very different process to what Lord Turner thinks is happening behind the scenes.”
However, Mr Turner isn’t against investing in peer-to-peer lending – he just wants people to understand the risk. “We need to encourage people only to participate in this if they have money which they can afford to lose,” he says. That is the key to IF Isa investing.
An innovative Finance Isa is not the place to put cash that you can’t live without. But if you are prepared to take on the risk with your extra cash, you could make some good returns.
“Those who want safety should usually focus on cash holdings, which are protected by the FSCS or by the government through National Savings & Investments (NS&I) products,” says Mr Connolly. “Those prepared to take more risk could consider peer-to-peer, but only as a small proportion of your portfolio.”
If you do want to invest in an IF Isa, there are a number of ways that you can manage risk. Firstly, go with an established peer-to-peer platform that has a provision fund in place to cover any defaults by borrowers and make sure your account would be covered by the fun - Zopa offers some accounts with higher returns that aren’t covered by its provision fund.
Also, check what its default rate is.
“RateSetter is an excellent example as it gives full details of its provision fund, including how much is in the fund,” says Mr Hagger. “There is a really interesting graph on the RateSetter provision fund page - it shows that the current default rate is 1.18% and that it would have to reach over 11% before lenders won’t receive full interest payments and 20% before their capital is at risk.”
Also, be wary of bumper interest rates. Some peer-to-peer companies are offering returns of up to 9%, but this is will above average and a clear sign that the borrowers are more risky - if they could get a lower rate loan they would. Keep your own risk down by avoiding these unusually high rates and sticking with the industry average of 3% to 6%.
This article was written on 1 March 2016, and as such, some of the data provided was yet to be confirmed. As of today (6 April), we can confirm that some of the big providers are not ready to launch their products.
RateSetter has issued an update: “[We] are in advanced stages of obtaining full authorisation – we cannot confirm a date yet but can confirm that it is progressing well.”
Zopa’s website states: ““Zopa is currently working with the FCA to be fully approved and ready to launch Isas in the next few months.”
Funding Circle’s website states: “We are hoping to have full FCA authorisation soon which will enable us to apply to become an Isa Manager.”
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
The Financial Services Compensation Scheme is the compensation fund of last resort for customers of authorised financial services firms. If a firm becomes insolvent or ceases trading, the FSCS may be able to pay compensation to its customers. Limits apply to how much compensation the FSCS is able to pay, and those limits vary between different types of financial products. However, to qualify for compensation, the firm you were dealing with must be authorised by the Financial Services Authority (FSA).
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.