Join the alt-fi revolution tax-free

Alternative finance (alt-fi) is set to move further into the mainstream after George Osborne, the chancellor, announced an “innovative finance” individual savings account (Isa) in his summer Budget.

This new type of Isa, which will be available from 6 April 2016, will initially provide a tax-free way of investing in peer-to-peer (P2P) loans. The chancellor will also launch a consultation on allowing mini-bonds and equity-based crowdfunding investments to be held in the account.

P2P lending, which enables individuals to lend money directly to small firms or individuals via platforms such as Funding Circle, Zopa and RateSetter, is growing rapidly: around £3.9bn has been lent through P2P sites to date, up 116% year-on-year, according to Investors have been drawn to P2P in search of higher returns than those available from bank deposits, with average one-year returns across the three largest UK platforms now running at 5.23%.

So it seems likely that the new innovative finance Isas will prove popular. However, any investors who are tempted to take their first steps into this area should bear in mind that a P2P Isa will bevery different from a cash Isa.

To begin with, P2P lending is much riskier. Although the industry is regulated, investments aren’t covered by the Financial Services Compensation Scheme (FSCS). Investors could lose money if the borrower fails to repay the loan as scheduled. Yes, default rates are low at present and some platforms run protection funds to compensate investors against losses. But the P2P lending boom has taken place while the economy is growing and the Bank of England has been holding interest rates at rock-bottom.

It remains to be seen how the sector will cope as rates rise or the economic cycle turns down. What’s more, the new Isa is likely to be much more illiquid than cash Isas or stocks and shares Isas. There is no requirement for investors to be able to withdraw funds within 30 days, although some platforms may offer the ability to exit early by selling your investments.

So if you decide to buy into a P2P Isa next year, make sure you understand the terms, conditions and risks. New users should consider opting for a platform that is a member of the P2P Finance Association, which has a strict code of conduct.