ISAs have been around for over 20 years now, with the first ISAs having been introduced in 1999. In 2016, the Innovative Finance ISA became the newest form of ISA, providing lenders with another opportunity to earn tax-free returns on their savings. An IFISA is both an alternative as well as an addition to the traditional ISAs such as stocks and shares and cash ISAs.
ISAs in General
ISAs allow savers to earn 100% tax-free interest up to the annual tax allowance limit. The current 2019-20 limit is £20,000. To benefit from the tax-saving protection, savers must use their allowance each year, unused allowance form a previous year cannot be rolled up into the next.
Cash ISAs
A cash Individual Savings Account (ISA) allows savers to earn tax-free interest on their savings and is generally suitable for short term savings goals of less than 5 years. Usually, interest rates on cash ISAs are fixed or variable depending on the terms. Similarly, your ability to withdraw or use your cash when you like also varies from cash ISA to ISA.
The rates of returns available on Cash ISAs do not vary as significantly as those available on IFISAs. The best Cash ISA in 2020 offers 1.7% AER, for a 5-year fixed-rate ISA, rates for flexible and instant cash ISAs are generally around 1.31% AER*.
The risk on a Cash ISA is quite low, akin to a standard bank account. You earn interest on the deposit and the banks use these funds to issue mortgages and loans. The banks profit from the margin, it's the difference of what they pay you (as the depositor) and what they charge to customers who borrow. They also profit from the re-hypothecation. Your £20,000 deposit contributes to Tier 1 capital. Banks in the UK must maintain at least 5.125% of Tier 1 capital. This means your £20,000 deposit allows the bank to issue up to £390,243.90 of lending. If a bank pays 1% interest on a cash ISA and charges its borrowing customers 10% interest pa, then it may earn £39,024.90 in revenue from the borrowers and pay you £200 taking a gross profit of £38,824.90. This is commonly known as 'balance sheet lending'. In this situation, you are receiving 0.51% of the reward. The banks also profit from compound interest.
As well as taking rewards, the bank takes the risk and cost of non-performing loans. So you are receiving 0% of the risk. However, even with a high margin, some banks make poor decisions, which is why the regulator has protections like FSCS, because the risk is the failure of the bank.
Innovative Finance ISAs
Unlike a bank that may decide what to do with your deposits, a peer-to-peer lending platform may only use your funds in accordance with your instructions. Either explicitly, via your lending choices or implicitly, via a mandate to follow your 'rules', for example with BidPal or BuyPal.
Depositing your funds does not earn you interest. Only once you begin lending, will you start to earn interest. Your borrowers pay interest to the platform, crediting your online wallet with each monthly repayment. With each repayment, you receive cash, which you may withdraw, hold or reinvest. If you reinvest each repayment, you will benefit from compound interest.
Most platforms take a small margin, but rebuildingsociety.com does not. So you receive 100% of the reward. However, in addition to the rewards, you also bare the risk and cost of non-performing loans.
Most platforms have a secondary market, allowing you to sell your position on the loan to another lender. Most secondary markets are quite liquid because most new lender money is employed via the secondary market. However, they are subject to buyer demand. In periods where there are few new lenders, demand may be low. You can influence the level of buyer demand through a premium or discount option when selling your loans.
A peer-to-peer platform does not fail due to poor lending decisions, because it is not losing its own money. Though it can fail from a loss of lender confidence and loss of customers, resulting in a loss of revenue.
The mandatory wind-down plan's in place means that a platform failure would not impact lenders in the same way as with a bank.
The peer BuyBack Guarantee reduces risks
Some loans on our secondary market carry a BuyBack Guarantee, which means that if a loan falls overdue by more than 60 days, the loan part you have will be bought back from you (by the lender who sold it to you), refunding your capital straight away. Buying these loans will cost a premium, so you’ll earn a lower rate of return on microloans with BuyBack Guarantees, but you have less risk.
All microloans on rebuildingsociety.com, even those without a BuyBack Guarantee, carry some level of security this can vary from a personal guarantee (from the borrower) to a 1st charge over a UK property. Enforcing security requires legal action, which may take years.
Building a diversified lending portfolio is a good way to spread your risk and returns. Instead of lending all your savings on a single loan, lend to several different businesses with different levels of security in different business sectors. So that if a single loan defaults or a particular business industry suffers, your overall returns won't be as adversely affected, and you’ll be able to offset a loss on one loan with the gains on another, hopefully resulting in a good overall rate of return.
Target returns vs variable returns
The returns on IFISAS generally vary considerably compared to those of Cash ISAs due to the different P2P platform models and risk. Typically, IFISA returns can range from 3% -20%. Some platforms offer 'fixed returns' through the use of a 'target return'. This is achieved by sharing the risk and reward across a portfolio of lenders, to achieve a target outcome.
Where a platform does not offer a 'target return' lenders should be aware of a lending lifecycle, whereby the first 18 months normally involved a honeymoon period of high returns, followed by a 12 month period of decline, before recovering to a 'risk-adjusted level', it can take 3 years before a portfolio stabilises and you should periodically check to see if your performance is above or below the platform average.
Summary
We understand that risk appetite is personal. We were born with a vision to give customers a better deal. So our mission has always been to help better align the rewards with the people taking risks. This approach has benefited the vast majority of our lender base.
It doesn't take much time or experience, you just need to have the attitude that you want your money to work productively for you supporting small UK businesses. It's not for everyone, but for those who join our community, we quickly become their preferred way of making a financial return.
Read more about our credit risk assessments
How do you Open an IFISA?
To start benefiting from the tax-free interest earnings offered by an IFISA you need to simply register as a lender on our platform, and open an IFISA account. You can then start contributing regularly to your IFISA account, or you can choose to transfer in funds from existing ISA accounts.
Once you have funds credited to your IFISA account you can start lending them to new loans that are listed on the primary marketplace or get your funds earning more quickly by buying existing loan parts from other lenders on the secondary market.
So as mentioned, to earn tax-free interest returns in an IFISA you have to get your money work, by lending it to UK businesses, which carries the risk of default.
To find out more about our IFISAs visit our FAQs
P2P investments not covered by the FSCS. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future.
Read more about the risks of lending
* (How to find the best cash Isa)
Read more: https://www.which.co.uk/money/savings-and-isas/isas/cash-isas/how-to-find-the-best-cash-isa-atnpd4b2rv3u - Which?.
