Innovative finance Isas: join the crowdfunding revolution and give your income a big boost

This April sees the launch of the innovative finance Isa, a new tax wrapper that’s been rushed into service to cope with the rapid evolution of the finance industry. Alternative finance – a broad term for all sorts of investments, such as peer-to-peer (P2P) lending and crowdfunding, that have emerged outside the traditional finance system – is booming.

In the last few years, we’ve seen the emergence of a whole new world of predominantly loan-based investment options through online platforms such as Zopa, RateSetter and Funding Circle. At the core of this innovation is an online lending revolution that aims to give investors returns by letting them lend directly to a wide range of borrowers. The yields available vary enormously, with most consumer-loan-based products in the 3% to 5.5% range, while lending to riskier small businesses and property-based projects might give you between 5.5% and 8% (although some smaller platforms can push that yield closer to 10%).

This all sounds exciting, but up to now there’s been a catch for investors who want to make their investments as tax-efficient as possible. These online investment platforms didn’t fit into the existing Isa structures. They are not backed by the FSCS compensation scheme, which limits how much money you can lose in approved accounts, so they are definitively not savings products (capital is very much at risk). And they are neither shares nor funds, so don’t qualify for a stocks and shares Isa. That’s why a new Isa structure was required.

So the launch of the innovative finance Isa is a welcome development for income investors. If used wisely, you should be able to build a portfolio of products that could give you a combined return of between 4% and 6% with relatively sensible levels of risk. However, there are no guarantees in this alternative world of finance, while there are many (mostly manageable) risks. As already discussed, your capital is very definitely at risk. The individuals and businesses you lend to might also default on their interest payments to you, or even default on full repayment.

At the moment these defaults are running at very low levels, but if interest rates shoot up or the economy slips into recession, I would expect default levels to rise substantially. In addition, the platforms arranging and administering the investments might go bust even if the investments continue to pay: in this situation, you might eventually get your money back, but the investments could be totally illiquid while this is resolved.

So you should only look at the innovative finance Isa as one part of a wider spectrum of investments. I absolutely wouldn’t put all your Isa capital into this adventurous spectrum of products. However, it could form a major part of your income-based investments alongside other bond and credit options, with the potential to give a big boost to the yields you can get.