The Innovative Finance ISA is the newest of the several ‘flavours’ of Individual Savings Account that have been tagged on to the original ISA in recent years. Investors are attracted by headline rates of return of 6-10%, but we think these schemes are much, much riskier than they look and that most investors should avoid them.
The Innovative Finance ISA allows investors to put their money into peer-to-peer lending to individuals or companies, and as of now there are over 30 firms offering such products.
Already, there have been a good number of failures, most notably London Capital & Finance, which issued £236 million of ‘mini-bonds’ to 12,000 investors, but collapsed in January.
The problem for investors is that while the firms providing the product may say they are authorised by the Financial Conduct Authority, the products they offer (like London & Capital’s) are not covered by the Financial Services Compensation Scheme (FSCS). That means if a business does go bust you may not get any of your money back.
Some Innovative Finance ISAs channel your money to specific individuals or companies. In this case, you take on all the risk that the person or business will fail to repay the loan, and advisers say you should undertake ‘due diligence’ yourself, even though in the case of a business this is close to impossible. Business failures are frequent, and several such IF ISAs have already lost money for investors. Alternatively, IF providers can ‘pool’ risk, so that your capital is spread over many loans. This reduces the level of risk, but you need to remember the maths. If ‘loan default’ rates are 3%, you need to deduct that 3% from the rate of return you can expect.
Moreover, peer-to-peer lending is a recent innovation. It has never been tested in a severe recession like that of the early 1990s. When unemployment shoots up, you would expect loan default rates to rise sharply.
The truth is that IF ISAs have risks much closer to those of stocks and shares ISAs than cash ISAs. And if you are reliant on the capital in your ISA and cannot afford to lose it, then we think IF ISAs are not for you. Returns on conventional cash ISAs may be pitifully low, but at least you can be sure that you will get your money back, and that it is protected by the FSCS.