How to use an Isa to invest in peer-to-peer loans
Since peer-to-peer (P2P) lending platforms began to enter the market in 2005, savers have used the services to hand out more than £10bn to borrowers.
Aside from providing a significant boost to the UK economy, P2P offers attractive interest rates to lenders by cutting the banking sector from the borrowing process.
The Innovative Finance Isa (IFISA) allows savers to hold their P2P loans within the Isa wrapper, keeping any returns they make away from the taxman. It’s also an option for investors who are looking to use up their remaining Isa allowance ahead of the end of the tax year.
Bypassing the banks
P2P platforms allows individuals to lend money directly to businesses that are looking to borrow. These borrowers will then pay the lender back their original amount plus a pre-determined amount of interest over a set period.
The loans are typically organised and sourced by online platforms such as RateSetter and Funding Circle, which are also responsible for credit-checking potential borrowers.
P2P loans can be issued in any number of different sectors.
The UK’s 5.2m SMEs make up one of the largest groups of borrowers. These small businesses use the proceeds to fund things like working capital, expansion, or new assets.
Another popular area is property, where money is loaned to finance anything from buy-to-let properties to residential property refurbishment.
Consumer lending is also standard, with small loans covering things like weddings, holidays, and home improvements.
Unlike P2P loans made outside the wrapper, where interest is taxed beyond the £1,000 personal savings allowance, all returns made on investments within the IFISA are tax-free.
Since the introduction of IFISAs in 2016, numerous P2P platforms have added the product to their offering.
Beyond the tax benefits, Paul Sonabend, executive chairman at P2P marketplace Relendex, says IFISAs and peer-to-peer platforms have opened up a type of lending that had only been available to very wealthy investors.
“Going back a few years, if an investor had £1m, they could find a borrower who could provide a good return on it,” he says.“However, if you only had a few thousand, it would more likely be sat in cash.”
P2P platforms and the IFISA allow lots of people to combine their savings and create a large figure to lend out, Sonabend explains, adding: “P2P lending has democratised investment and given everyone the chance to access these strong returns.”
IFISA solutions primarily come in two forms. Some providers allow lenders to pick from a selection of loans sourced on their platform within the IFISA wrapper. Others provide a managed IFISA service, where a customer defines their risk preference before a portfolio of borrowers is assembled on their behalf.
Some platforms offer both services.
Andrew Lawson, chief product officer at peer-to-peer platform Zopa, says that the managed approach is better suited to investors who don’t have any lending experience.
“To pick individual loans, you need to have specific knowledge and interest,” he says. “If you can find a platform with expertise in credit risk, pricing, and the servicing of loan contracts, you can rely on them to find the right borrowers for you. You can also rely on them to handle lending in the most profitable way possible. This is an excellent solution for everyday investors.”
Risky business?
In exchange for their services, P2P platforms typically charge a fee to either the borrower or the lender. Some will also charge a one-off setup and onboarding fee.
With minimum investments, projected returns, and track records also varying between operators, it is important for savers to compare services and ensure they get the best deal.
However, because they are using online portals to cut banks out of the lending process, most platforms are likely to generate more interest than a traditional savings account.
IFISA returns have averaged around 5.75 per cent annually, with some products offering more than eight per cent, according to Relendex. In comparison, Cash Isas averaged a paltry 0.8 per cent return last year.
That being said, the very nature of lending means that there is more risk attached to an IFISA than cash.
When an investor hands over their money to any borrower, there is a chance that they will not get it back. This risk of default can be apparent in the P2P market, simply because some borrowers are owners running young businesses, while others operate in cyclical areas like property.
Another thing to bear in mind is that, while the P2P market is fully regulated by the Financial Conduct Authority, it is not covered by the Financial Services Compensation Scheme, which applies to most bank accounts and Cash Isas.
To protect against elevated risk, many IFISA providers will operate reserve funds. These are designed to cover their customers’ savings – plus interest – if a borrower defaults.
Operators also diversify their loan book across a large number of borrowers. In a similar way to how a fund manager diversifies investments across asset classes, this ensures the spread of client money between loans in different sectors with varying risk levels and duration.
Lawson says that it is best to think of an IFISA as a medium-term investment with at least a five-year term, because diversification naturally increases as repayments are made and new loans are issued.
Slow burner
After a slow start, IFISAs appear to be increasing in popularity.
Government statistics show that the amount invested in the products rose to £290m in 2017-18 from £36m in 2016-17. Jake Wombwell-Povey, the co-founder of direct lending platform Goji Investments, which offers two IFISA-eligible products, says one reason could be that savers are shying away from Stocks and Shares Isas.
“At a broad level, stock markets are down, and there is a lot of political uncertainty driven by factors like Brexit and trade,” he says. “Many investors will not want to put their money into equities through the Stocks and Shares Isa at the moment because excessive volatility can greatly increase and decrease value daily. In comparison, IFISAs tend to have target returns that are more predictable.”
With average Cash Isa rates sitting below the UK’s current 1.8 per cent inflation rate, Wombwell-Povey says the IFISA also provides these savers with a better solution than leaving their money uninvested.
‘This dynamic means Cash Isas savers are losing in real terms as their cash is eroded by inflation, even if it is safe,’ he says. “All-in-all, the IFISA looks like an attractive middle ground that provides above-average returns without equity market volatility.”