What is the Innovative Finance ISA?
The Innovative Finance ISA, or IFISA, is a new form of tax wrapper which will allow UK savers to lend money out via peer-to-peer lending platforms on an income tax-free basis. It will operate using similar mechanics to a regular cash ISA.
How is the Innovative Finance ISA taxed?
Following the introduction of the Innovative Finance ISA in 2016, eligible IFISA-wrapped interest will be tax-free.
Presently however, income tax has to be paid on all interest earned via peer to peer lending platforms – at that individual tax payer’s marginal tax rate.
To illustrate; under the current regulations, 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% or £400.
From April 2016 the new Innovative Finance ISA will allow certain approved peer to peer platform providers to effectively ring-fence this income in a tax-free ‘pot’ – in exactly the same way that a saver can already do with a cash ISA savings account.
How do Innovative Finance ISA returns stack up against Cash ISA returns?
The first thing to consider is that the two forms of investment class have very different risk profiles. Presently, cash ISAs are for the most part covered under the Government’s Financial Services Compensation Scheme. This means that if the bank or building society were to fail the investor would remain entitled to receive back their capital – which is effectively underwritten by the Government up to a cap of £85,000 per institution.
The peer to peer finance sector is not governed by the FSCS. There is no government guarantee that any amount of the loans that you as an investor make will be repaid by the Government in the event that either the borrower were to fall short of their repayment duties, or if the platform were to fail.
That said, there are nominally higher interest rates to be gained from peer to peer lending than from cash saving – at least for the time being. Cash ISAs are currently paying very low interest – perhaps 1%, which, given inflation, is actually a negative return.
Conversely, peer to peer platforms are offering returns frequently in excess of 5% and sometimes up to 15% for certain opportunities.
These higher interest opportunities do often have a degree of risk mitigation – many are asset-backed, or secured over a property or other significant asset. However, it would be wrong to suggest that the two forms of saving are on comparable risk terms. The reality is that each individual saver and lender 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. The reality is that, on the balance of probabilities, each individual who enters the peer to peer lending sector will need to make a balanced assessment of how much of their capital should be deployed into peer to peer lending vis a vis cash saving, equities, bonds and any other asset class that they may be considering.
How do the Innovative Finance ISA providers make their money?
Most Innovative Finance ISA providers are expected to 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 from the borrower. In others, fees are taken from the lender. In many cases, fees are taken from both. Some pay interest out monthly, some quarterly – and some roll the interest up and only pay out at the end of the loan term. Some platforms also have 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 i.e. if one were to deposit £10,000 with a given platform one would only expect to be entitled to receive interest to the extent that the platform itself had managed to pair that capital up with a borrower and actually transact a loan agreement. If the platform was offering 10% but had only managed to commit 30% of the £10,000, the reality of the situation is that that lender has really only deployed £3,000 – and the 10% interest would only be being generated based upon this £3,000 – not on £10,000.