Innovative Finance ISAs: The Returns Can Be Great but How Risky Are Peer-to-Peer Loan Investments?

Cash ISAs have plummeted in popularity. Over the 2017/18 tax year, there were 8.5 million active cash ISA accounts compared to 10.1 over the previous year. The amount put into Cash ISAs dropped by considerably more, down 33%. If there is anything surprising in those statistics it can only be that Cash ISAs remain relatively popular despite it being almost impossible to get a better interest rate than around 0.5%. The inflation rate has been around 2.5% in recent times, meaning Cash ISA holdings are losing value when considered, as it should be, in terms of purchasing power.

It has taken a long time for the UK’s savers and investors to cotton on to the fact Cash ISAs simply don’t make sense under current interest rate conditions. Ironically, the penny seems to have dropped just as interest rates are beginning to tick back up again. Stocks and shares ISA returns are generally much better when averaged out over 10 or 20 years. 5% per year after fees is perfectly achievable with a relatively conservative portfolio of mainstream funds. Of course, the downside is that because the stock market moves up and down, stocks and shares ISAs can lose significant value over a few years. So capital tied up in stocks and shares ISAs really has to be with a longer term outlook so any market downturns can be ridden out. 

There’s also a third category of ISA. It allows for inflation beating returns, often superior to those of a stocks and shares ISA with modest risk profile, and they aren’t directly correlated to financial markets - the Innovative Finance (IF) ISA.

What is an Innovative Finance ISA?

The innovative Finance ISA was launched in 2016. These ISAs have the same annual allowance and structure as standard Cash and Stocks and Shares ISAs but accommodate a different asset class – P2P loans. Like the other main ISA categories, holders of an Innovative Finance ISA can put all of their £20,000 allowance into P2P loans or spread allocations across an IF, stocks and shares or Cash ISA. One of each category may be opened each year.

Data provided by the Cambridge Centre for Alternative Finance indicates that around £10.6 billion has been invested in P2P loans since 2011. The Innovative Finance ISA was created to address this demand from UK investors and shelter them from the income tax and capital gains tax that would otherwise be applicable on P2P loan investments held outside of the ISA wrapper.

Existing ISAs, such as Cash ISA balances from previous years, can also be transferred into an IF ISA, though any previous P2P loan investments made outside of an ISA wrapper cannot.

Peer-to-Peer Loans Explained

So what exactly are P2P loans and how do they work? Peer-to-peer loan platforms sprang up in the wake of the 2008-09 financial crisis. In the UK, the term ‘Credit Crunch’ was coined by the media as the headline of choice for articles on the impact and progress of the global financial meltdown and the localised situation in the UK. The ‘credit crunch’ term came out of the fact that many banks in the UK and around the world took major losses as a result of their exposure to toxic derivatives such as the sub-prime mortgages that led to the collapse of Lehman Brothers. That put their balance sheets under severe pressure, many including RBS and Lloyds had to be bailed out by governments, and while they were putting their houses in order lending became severely restricted. Even banks which were not so badly effected found it difficult to access the inter-bank liquidity loans or to hedge the risk their loans were exposed to so were also forced to reduce lending.

At the same time, interest rates were slashed to historic lows by the Bank of England and other central banks around the world, including the Federal Reserve in the USA. This was intended to stimulate borrowing and kick start economic growth but also made it less financially attractive for banks to offer loans, especially to all but the lowest risk profile borrowers.

P2P lending appeared to help fill the market need banks were no longer catering to. It also offered investors and savers a way to earn a reasonable return with interest rates on cash savings negligible to non-existent and many still reticent to put their money back into stock markets that had recently crashed by between a quarter and close to 50% of their recent value.

Borrowers on P2P lending platforms fall into three main categories of individuals, SMEs and property developers. The platform assesses their credit worthiness in much the same way a bank would and assigns an interest rate considered to reflect that. Interest rates are slightly higher than would normally be the case through traditional lenders (typically anywhere between 3.5% and 12%), to incentivise investors and compensate the level of risk they are taking on, but allows borrowers access to credit likely to be denied by new, stricter bank lending policies.

Source: The Times

Different P2P lending platforms specialise in different kinds of loans such as those to individuals, SMEs or property developers. Some offer loans over all three categories. The commercial model also differs between platforms with some taking a cut of the interest rate, some charging a loan brokerage fee that is usually a percentage of the loan value and others a hybrid model between the two.

Different P2P Lending platforms also have different minimum investment levels, which can range from as low as £10 to as high as £5000 or more. Asset backed loans such as alternative mortgages often have a higher minimum investment level and lower interest rate to reflect their relatively lower risk profile.

How Risky Are Peer-to-Peer Loans

Innovative Finance ISAs should not be considered as a direct, higher interest, swap for a Cash ISA. P2P lending is a form of investment and not saving and so involves risk.  That’s why it P2P Lending offers investors returns in the form of the interest rate that is usually around 7% or more and usually a minimum of 4%-5%. Reward involves risk.

So what is the average default ratio on P2P Loans? The different P2P Loan platforms publish default figures, which prospective investors should pay close attention to and build into their returns projections. Platforms often publish projected default figures for the year and actual defaults. In 2017, Zopa, a major UK P2P lending platform projected defaults at 4.98% but, as of late August, actual defaults were just 0.08% of all loans brokered and arrears at more than 45 days 0.21%. RateSetter said that over the lifetime of the business from 2011 to 2017, 1.7% of loans were in arrears. Funding Circle have published figures of 2% of loans going bad and Lending Works had a bad debt ratio of 1.1%

Also, unlike in the case of funds held in a bank account, Cash ISA or in a stocks and shares ISA held with an online stock broker or investment platform, P2P Lending platforms are not covered by the Financial Services Compensation Scheme (FSCS). This guarantees £85,000 in the worst case scenario of the bank or financial services provider failing.

What’s The Best Strategy If I Invest in Peer-to-Peer Loans?

As with any sensible investment strategy, the best way to approach P2P Lending through an Innovative Finance ISA, if you decide it’s for you, is to diversify risk. It would be very unwise to expose all or a large percentage of invested capital to any one loan. Funding Circle, which specialises in loans to SMEs, advises investors to not allocate more than 1% of capital to any one loan, spreading it across at least 100 businesses.

Of course, this being practical depends on the minimum investment requirement of your chosen platform and the value of your investment. £10,000 spread between 100 loans would mean the minimum investment would have to be £100, though this is generally even lower, down to £10, for retail investor-facing P2P lending platforms.

With most P2P lending platforms, you will have a choice between either choosing the loans to finance yourself, or diversification being automated and the platform spreading your investment between loans. In most cases, it won’t be practical for you to assess 100 different loans yourself and the automated diversification option will make more sense.

If you are considering taking on a higher level of risk and allocating a bigger investment to one particular loan, then you will probably take some time to personally evaluate the credit worthiness of the borrower.

Peer-to-Peer Loan Brokers

There are a number of considerations to keep in mind when deciding on a P2P Lending platform through which to invest in an Innovative Finance ISA. Investors should research the company and a longer track record and experienced management should be considered an advantage. Another metric to gauge is the value of loans provided to date and over the past couple of years. A platform may have been around for a while without recording substantial growth, which can be considered a potential red flag. Newer platforms should also not necessarily be discounted entirely but closer scrutiny applied to their management and backing.

Choosing a P2P platform that is regulated by the Financial Conduct Authority should be a minimum requirement as not all are. Also, be aware that being registered with and regulated by the FCA are not the same thing. The latter provides a level of insurance around the company’s finances and business practises, while the former only really means that the FCA is aware that the company is offering financial products and theoretically agrees to do so within the framework of the law.

The next quality to assess is the kind of loans the platform offers. Are they to individuals, business, property-backed alternative mortgages, property developers or some or all of these categories? You may be only interested in one or some of these categories so will want to choose a platform that offers those.

The next consideration is if the platform allows you to choose the loans you will be invested in yourself, offers an automated matching service based on your chosen risk to return ratio or both are possible. There’s no point choosing a platform that doesn’t allow you to choose your own loans if you would prefer to have that option and vice versa, not to offer an automated loan diversification service if that’s what you want.

Finally, a key consideration is of course the minimum investment levels for both opening an account and per funded loan. If you will start with a smaller sum of capital to invest you should choose a platform that allows for small stakes in loans. This will allow you the diversification you need to keep default risk at a minimum and absorbable across the whole portfolio without impacting overall returns too much if a small percentage of the loans do go bad.