What is an Innovative Finance ISA?
An Innovative Finance ISA, or IFISA, is an ISA account that facilitates peer-to-peer (P2P) lending investments.
Peer-to-peer lending allows you to loan your savings directly to borrowers without the need to go through a bank or building society.
A borrower could be a company, charity, or even an individual taking out a loan.
An IFISA provider offers a target return rate on the cash you invest, and because your investments are held in an ISA you don’t need to pay tax on your profits.
How does an Innovative Finance ISA work?
To open an IFISA you will first need to contribute some money to your account. You have an annual ISA allowance of £20,000 which is the maximum amount you can contribute in the 2022/23 tax year.
Once your account is open, you usually pick one or more peer-to-peer lending products to invest in. Some providers pick your investments for you, while others require you to choose yourself.
Each P2P lending investment has a target return interest amount that your provider aims to pay you in interest per annum.
Some providers allow you to diversify your investment by investing in multiple investments within your one IFISA.
When you want to withdraw your money, you can do so as soon as you sell your underlying loans. This is where risk becomes a factor in P2P lending as your IFISA provider will need a buyer to purchase the loan you are selling.
If your loan is performing poorly, it may take a while to sell or you might not even be able to liquidate it.
P2P loans typically lend your money to an individual, a company or a charity. These borrowers could be taking a loan for home or property developments, business loans, car financing or medical expenses, and they will pay the interest that comes back to you via your provider.
What are the risks involved with Innovative Finance ISAs?
You need to be aware that you can lose money in an IFISA as well as earn a profit.
Your underlying investments are not guaranteed to generate the interest rates they aim for, and they could even go down in value if your borrowers get into trouble.
If a borrower defaults on the loan you have invested in you could lose some or all of your investment. It could also take a long time to liquidate your investments compared to a Cash ISA or Stocks and Shares ISA that you can usually sell down in a week.
This is why it is important to diversify your investments across multiple products to protect your portfolio’s overall value.
Check the FCA Register
Innovative Finance ISAs are regulated by the Financial Conduct Authority (FCA), so make sure to check the FCA Register for the company you open your account with.
Financial Services Compensation Scheme (FSCS)
Unfortunately, IFISAs are not covered by the FCSC like Stocks and Shares ISAs and Cash ISAs are.
The FSCS covers investors for up to £85,000 if their product provider goes into administration and cannot release their money. This means if your IFISA goes bust, you could lose your investment which adds a layer of risk to these products.
You need to agree to several risk acknowledgements when you open your account. For example. the fact that your borrowers can miss payments or default on their loans resulting in you needing to hold your investment for longer.
Additionally, if your borrowers are using a property as collateral for their loan it could depreciate in value or take a long time to liquidate. This can also affect the value and accessibility of your investment.
What are the Tax Benefits of an Innovative Finance ISA?
With standard P2P lending, the interest you earn from your investments is subject to tax from HMRC.
Depending on how much interest you earn from other sources and your income tax bracket, this could mean you pay a considerable amount of tax on your earnings.
How does tax on interest work?
If you earn less than £17,570 per year, you qualify for a £5,000 Starting Rate for interest savings that you don’t have to pay tax on. But, this is reduced by £1 for every £1 you earn over the basic rate tax threshold of £12,570.
For example, if you earn £15,000 in a tax year, £2,430 will be deducted from your £5,000 allowance, leaving you with only £2,570 worth of your tax-free savings allowance
HMRC also grants you a Personal Savings Allowance. This is £1,000 for basic rate taxpayers, £500 for higher rate taxpayers, and £0 for additional rate taxpayers.
How much tax will I normally pay on interest?
The tax you do pay is calculated at your income tax bracket for that tax year. This could be up to 45% if you are an additional rate taxpayer.
The benefit of an IFISA is that any interest you earn from your P2P loans within it is completely free of tax.
You don’t even have to declare the interest on your tax return.
Can I transfer my standard peer-to-peer loan investments into an Innovative Finance ISA?
If you have non-ISA P2P lending investments you are probably wondering how to get them into an ISA to enjoy the tax benefits.
Unfortunately, you cannot transfer them in directly.
This is because HMRC only allows cash contributions to IFISAs (or any other type of ISA) so they can record the monetary value of each contribution against your personal allowance.
You also cannot Bed and ISA a P2P loan into an IFISA like you can with shares into a Stocks and Shares ISA.
Your only option is to completely sell your existing investments, open an IFISA, and then invest in either the same products if they are available or a new P2P loan investment.
Can I transfer a Cash or Stocks and Shares ISA into an Innovative Finance ISA?
Yes, you can transfer some or all of your other ISAs into a new or existing IFISA, but there are a few things to keep in mind:
- You might be charged by your existing Stocks and Shares ISA provider for transferring away
- If you are transferring from a Cash ISA, make sure you are not exiting any fixed interest periods as you could be charged for this or lose your interest
- You could also be charged an account closure fee
- Transfers can take between 4 to 6 weeks to complete
- You must transfer 100% of your current tax year’s subscriptions
- You can transfer any amount of your previous year’s ISA subscriptions (partial transfer)
- Your ISA transfers do not count towards your annual ISA allowance of £20,000
To transfer, speak to your new IFISA provider. You will need to complete and sign a transfer form, but your provider will administrate the transfer on your behalf and the process is fairly hassle-free.
Make sure you do not just withdraw your existing ISA to your bank account and then add the money to a new IFISA. Withdrawing results in your money losing its ISA status, and so when you go to add it to your IFISA it will use up your annual ISA allowance, and you will not have a big enough allowance to get it back in if it is over £20,000.
Can I have a Stocks and Shares ISA and an IFISA at the same time?
Yes, you can have a Stocks and Shares ISA, Cash ISA and IFISA all open at the same time. However, there are a few rules to be aware of:
- You can have two or more IFISAs open at once
- You cannot contribute to more than one IFISA in the same tax year
- You can contribute to an IFISA, Stocks and Shares ISA and a Cash ISA in the same tax year, but you cannot go over the combined allowance of £20,000
- For example, you could contribute £10,000 to an IFISA, £5,000 to a Cash ISA and £5,000 to a Stocks and Shares ISA
What is the best Innovative Finance ISA?
There are two main considerations when you are comparing Innovate ISAs:
1. What Innovative Finance ISA provider to go with
2. What peer-to-peer lending product to invest in
When choosing the best IFISA provider for you, you should ask:
- What are the account charges (ongoing and ad hoc)?
- What is their customer service reputation?
- What kind of products do they offer (select your own or auto-select, and how many options are available)?
To decide what product to invest in, the main points to consider are:
- What is the target return?
- How long do you have to stay invested for?
- What is the minimum amount you can invest?
- What are the management fees of the investment?
- What is the risk level associated with the investment?
What are the alternatives to Innovative Finance ISAs?
The key alternatives to IFISAs are Cash ISAs, Stocks and Shares ISAs, Lifetime ISAs and Junior ISAs.
All these accounts have the same tax benefits, so the differences are mainly to do with the investments you can hold within them and some other benefits.
Stocks and Shares ISAs
You can invest in managed funds, shares tracker funds and many more investments.
You will not have a target interest rate with this type of ISA and your investments will rise and fall in value, but you could benefit from greater growth and income potential.
You can easily diversify your portfolio with a Stocks and Shares ISA by investing in various different companies, sectors and geographical regions.
A Cash ISA will provide you with a guaranteed fixed or variable interest rate. Unlike with an IFISA, your investments cannot fall in value.
However, the interest rates on offer will be considerably lower, and your investments might not even be able to outperform annual inflation rates.
LISAs can be held as either Stocks and Shares or Cash. You cannot currently open an Innovative Finance Lifetime ISA.
All of your investments into a LISA will benefit from a government bonus of 25% free; however, you cannot withdrawal until age 60 unless it is towards a first house deposit.
If you withdraw earlier, you are charged 25% which is more than the original bonus. E.g., a £4,000 contribution becomes £5,000 after the 25% bonus, but a withdrawal of £5,000 only gives you £3,750 back after the 25% charge.
You have an annual LISA allowance of just £4,000, and this is linked to your normal annual ISA allowance. For example, if you contribute £4,000 to a LISA, you can only contribute £16,000 to an IFISA or any other type of ISA.
JISAs are tax-efficient savings accounts for children. They can only be opened by a child’s parent or legal guardian, but anyone can contribute to their account.
They cannot be accessed until the child is 18, at which point they are automatically converted into a standard ISA in their name.
As with LISAs, JISAs can be held as Cash or Stocks and Shares.
Each child has an annual JISA allowance of £9,000, and they can only have one account open.
Normal peer-to-peer lending investments
If you have used up your entire ISA allowance and still want to invest in P2P lending products, then you could hold the investments outside of an ISA.
However, you will be subject to tax on your investments as we have looked at earlier, so your returns will likely be diminished depending on your other income sources.
How do I open an Innovative Finance ISA?
You can open an IFISA online, over the telephone or by post.
You will need to create an account, agree to the risk declarations, and make a contribution via debit card or Direct Debit to invest.