August 8, 2020 Last updated August 8th, 2020 1,270 Reads share

What Are the Risks of Innovative Finance ISAs?

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What Is an Innovative Finance ISA? 

Peer to peer (p2p) lending has been around for a long time; however, as the tax-free service for investing in it just arrived three years ago. None of the major peer to peer lenders in the market offered IFISA when it was first launched. But, now, three of the biggest platforms, including Kuflink, Funding Circle, and Zopa, all offer Innovative Finance ISA.

Peer to peer lending includes an investor who uses a platform to lend loans to businesses or consumers in return for an interest rate. There seem to be two separate narratives for Innovative Finance ISA in the market. The first one is that IFISA is a middle ground that offers an alternative for people who want higher returns than cash ISA. The second narrative is that ISA is the banking which cuts out the middleman. 

The fact is that none of these narratives are entirely accurate. Traditional banks don’t work this simple, and there is a middleman, which is the p2p platform. However, IFISA does remove the majority of the costs which the bank incurs as a middleman. This means that investors get a better return with outing bumping up the interest rates for borrowers.

What Are the Risks?

Before you invest your money into the IFISA, you need to be aware of all the risks. The risks of investing in Innovative Finance ISA are generally the same as the risks involved in peer to peer lending. Most of the people who invest in the Innovative Finance to lend money take part in a p2p loan. The significant difference is that the lending is completely covered up in a tax-free kind of lending account. 

Higher Costs

Whenever you are charged more money to lend via an IFISA platform, then it means higher risk. 

Let’s understand this through an example. Let us assume that a borrower pays 10% of the interest rate. And the p2p provider takes out a cut from the middle, so the lender only receives 6.5% before bad debts.

If you need to wrap up your lending in innovative finance and the p2p provider charges you an extra 1% point, although you are lending in the same loans. This means that you will make 5.5% before bad debts. 

In short, the more charges eat into your investment returns, the more chances of you making a loss. Hence, you have to be careful about any additional layer of fees when you lend in an Innovative Finance ISA. You may need to pay a small extra charge for a few administrative items. For instance, you may pay a fee for transferring your money to another ISA. Usually, this should not have much of an effect on you. Still, you have to look out for regular ongoing extra charges with some of the IFISA providers. This can occasionally be 1% or more. The effect of one percent fees each year for 20 years can cost you £3,000 or more in returns on a £5,000 of initial lending. That is £3,000 fewer interest returns to cover possible bad debts. 

However, the good news is that the majority of the Innovative Finance ISA providers don’t charge any more for you to lend via an IFISA than they would do for their regular p2p lending accounts.

The Risk of Being Tied to Innovative Finance ISA

With IFISA, the lenders have the freedom to select whether they would like to stick with their existing Innovative Finance ISA after their loans are repaid or sole, or whether they would like to move on. Still, people who are busy dealing with jobs, hobbies, families, and other stressors tend to delay important decisions when it is a chore. Sometimes it is known as the “Inertia Risk.” In simple words, due to your laziness, you are tied up to the same Innovative Finance ISA provider. 

Switching IFISA providers can be a bit of a chore compared to switching p2p lending accounts. After you have sold your loans or are waiting for them to be reimbursed or you usually have to complete a paper form and wait many weeks for your earnings to transfer to other Innovative Finance ISA. This can seem off-putting; hence it is up to you to make sure that your laziness or busy-ness doesn’t lead you to do anything when it is time for you actually to do something. 

There is a limitation on the number of IFISAs you can invest in, in one year. This decreases the number of loans and peer to peer lending sites that you lend across. This raises your risks if you do not stagger your savings and invest some of it somewhere else.

To combat that, a few aggregators are providing Innovative Finance ISA, which combines loans from different p2p lending sites. However, all those IFISA providers come with the above-mentioned higher fees.

One other drawback could be that there are a few lenders that could quickly end up putting a little more money into just one Innovative Finance ISA because of the apparent difficulty in opening different accounts in a short amount of time.

How to Lower Innovative Finance ISA Risks

There is a way through which the Innovative Finance ISA risks can be reduced. This can apply to extra-rate taxpayers. It also applies to primary and high tax-rate payers, if the amount of interest that you earn through both savings and lending accounts is higher compared to your Personal Savings Allowance. 

Since you aren’t taxed depending on your returns in IFISA, this gives you an extra buffer of money for the coming years when your return may be closer to zero, for example, during a severe recession and property crash. Mainly, if you like lending in higher risk loans, the spare money you keep by dodging the taxes through Innovative Finance ISAs may ensure that you do not make a loss.

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Sana Tahir

Sana Tahir

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