Innovative Finance ISA FAQ
1. What is the Innovative Finance ISA?
The Innovative Finance ISA, or IFISA, is a new tax wrapper which will allow UK investors to lend money using FCA-regulated peer-to-peer lending platforms and receive interest and capital gains tax-free. It will operate alongside and use similar rules to the established Cash ISA system.
2. What is peer to peer lending?
Peer-to-peer lending is a rapidly growing, FCA-regulated form of investing in which people with money who are looking to achieve an interest return are able yo lend collectively to credit-checked individuals and business who are looking to borrow.
Peer to peer loans are typically organised and transacted via online peer to peer ‘platforms’, such as RateSetter, Funding Circle and Zopa. The purpose of these peer to peer websites is to source and credit-check the potential borrower, to facilitate the loan and to automate, where possible, much the various legal and regulatory processes involved in creating a lending relationship.
Over the past 10 years, the peer to peer lending platforms have become an increasingly strong force, serving a borrower need which had historically been served only by traditional banks and building societies. The key difference, however, is that online peer to peer platforms have a much lower overhead than a traditional banking model would require. The result is that the borrower is able to access credit at a lower rate, yet, in contrast to the banking model, a greater portion of this interest can be passed on to the lender. The resultant effect is that – in basic terms – the borrower can pay less interest than he or she would otherwise pay using a bank, and the lender receives a greater amount of interest than he or she would otherwise be entitled to from a bank. In effect, the interest rate ‘spread’ taken by the bank has been eroded.
Over £5+ billion has been lent in the UK by the peer to peer lending sector so far – and the numbers show no signs of slowing down any time soon.
More information can be found in our guide to peer to peer lending.
3. Is peer to peer lending a regulated industry?
The UK peer to peer lending sector is now fully regulated by the Financial Conduct Authority (FCA). The FCA was previously known as the Financial Services Authority (FSA).
There is an industry body too – the Peer-to-Peer Finance Association.
4. Is peer to peer lending the same as using bank savings account or Cash ISA?
No – peer to peer lending and bank savings accounts are not direct substitutes. Whilst the interest rates that are available to peer to peer lenders are much greater than are presently available from the high street bank and building society Cash ISA accounts, the risks are relatively greater and lenders’ capital is at risk.
We have covered the key risk differences in our guide to peer to peer lending, though perhaps one of the key take away points from a risk perspective is that the peer to peer lending industry is not covered by the Financial Services Compensation Scheme (FSCS).
For most bank and building society account holders, the FSCS acts as a back-up guarantor of the first £75,000 in savings that any UK individual holds with that banking institution. At this time, the FSCS does not cover peer to peer lending activities.
5. How is peer to peer lending income taxed?
Following the introduction of the Innovative Finance ISA in April 2016, IFISA interest and capital gains will be tax-free.
Outside of the IFISA, tax has to be paid on all lending interest received via peer to peer lending platforms at that individual taxpayer’s marginal tax rate. In effect, the interest received will be added to the lenders’ total taxable income, and taxed accordingly.
Outside of the IFISA, a £10,000 portfolio of peer to peer loans yielding 10% interest will yield a gross interest return of £1,000 per annum. A basic rate taxpayer would be expected to complete a tax return and to pay tax at 20% (£200). A higher rate taxpayer would be expected to pay 40% (£400) and an additional rate taxpayer would be expected to pay 45% (£450).
With the Innovative Finance ISA peer to peer income and gains will be ring-fenced in a tax-free ‘pot’. In this example, there will be no tax to be paid on the £1,000 interest received.
Note: the Personal Savings Allowance (PSA) introduced in April 2016 will allow lower rate taxpayers to receive their first £1,000 of interest tax-free regardless of whether it is earned through an ISA. This number is reduced to £500 for higher rate taxpayers.
6. How do expected Innovative Finance ISA returns compare to Cash ISA returns?
Cash ISAs operated by UK banks and building societies are covered by the Government’s Financial Services Compensation Scheme. This means that if the bank or building society were to fail, the saver would remain entitled to receive back their capital – which is effectively underwritten by the Government – up to a cap of £75,000 per person, per banking institution.
Conversely, the peer to peer finance sector is not governed by the FSCS. There is no guarantee that any amount of the capital that an investor deploys into peer to peer lending will be recovered in the event that either the borrower or the platform were to fail or otherwise fall short of their repayment obligations.
Conversely, Cash ISAs are currently paying relatively low interest rates which, given inflation, often resulting in a negative ‘real’ return to the saver because prices may be rising faster than the Cash ISA is paying interest. Higher target rates of interest are available from peer to peer lending than from cash saving. Indeed, peer to peer platforms offer target returns frequently in excess of 7% – and some in excess of 10% for certain opportunities.
Peer to peer lending platforms often seek to mitigate risk by making sure their loans are asset-backed, i.e. they seek to secure the loan over a freehold property or other significant asset which could be sold off in the event that the borrower to default on his or her repayment obligations. However, it would be wrong to assume that the two forms of investing, peer to peer lending and cash saving, carry identical risk profiles. The position is such that each individual will need to assess his or her own risk appetite towards the relative merits and risks that are associated both with Cash ISA saving and peer to peer (Innovative Finance ISA) lending. Each individual who enters the peer to peer lending sector will need to make a balanced assessment of how great a proportion of their capital, if any, should be deployed into peer to peer lending vs (for example) cash saving, equities, bonds and any other asset class that the individual may be considering.
7. How do the Innovative Finance ISA providers make money?
Most Innovative Finance ISA providers take the form of online peer to peer lending platforms. Each platform has its own fee structure and lending model. In some cases, fees are taken exclusively from the borrower. In others, fees are taken from the lender. And, in many cases, fees are taken from both borrower and lender. Some platforms pay interest out monthly, some quarterly – and some roll the interest up and only pay out at the end of the loan term. Many platforms take a ‘spread’ – a proportion of interest paid by the borrower is kept by the platform, with the residual interest paid to the lender. Some platforms also have one-off setup and onboarding fees which need to be paid before either borrower or lender can actually conduct a transaction.
It is also worth considering that many platforms only pay interest on funds that are deployed, meaning that if a lender were to deposit £10,000 with a given platform that platform may pay the lender interest only to the extent that it managed to deploy that capital with a borrower. If the platform quoted 10% but had only managed to commit 30% of the £10,000, the 10% target interest would only be paid out on £3,000 – not on £10,000.