More than £1bn has flowed into Innovative Finance Isas since their creation in 2016, with significant sums transferred from cash Isas savers in search of a better return.
The returns can certainly be more attractive than cash — but those who invest in peer-to-peer loans are taking much more risk, underlined by the collapse of several platforms last year.
This rattled the Financial Conduct Authority (FCA), which introduced limits for retail investors using the tax-free accounts to invest in peer-to-peer loans and other non-market linked securities.
Critics caution that many consumers do not understand the risks of peer-to-peer, and even seasoned investors will be concerned about how the economic fallout from the coronavirus could affect the health of the underlying loans or affect liquidity.
Risk vs return
Advisers say annual returns of about 5 per cent are not unusual for peer-to-peer investments, but performance has declined over the years as more platforms enter the market and compete to offer attractive loan rates to borrowers.
According to a report by Link Group, net returns have consistently fallen for the past few years, from their 2016 peak at 6.3 per cent to 4.4 per cent in 2018 and 3.8 per cent in 2019.
Hargreaves Lansdown reports that some IF Isas have seen returns greater than 14 per cent since launch — significantly higher than the low interest rates on cash Isas, but less than many equity portfolios would have produced.
“The first thing people need to remember [is that] these are investments, not a savings product,” said Charlie Taylor, head of property secured lending at the Octopus Choice platform, where average rates of return have fallen from 4.3 per cent in 2017 to 4.08 per cent last year. “If you don’t want to take risk with your savings, Innovative Finance Isas are not for you.”
IF Isas got off to a slow start after their 2016 launch as providers waited to obtain regulatory authorisation, but investments in the accounts totalled £1.14bn in 2019 according to platform data.
RateSetter, one of the UK’s biggest platforms, estimates that a total of 85,000 IF Isa accounts have been opened. On its own platform, 20 per cent of IF Isas have been rolled over from cash Isas.
IF Isas can hold both peer-to-peer loans and other debt-based securities. The most common P2P loans are those advanced to consumers, small businesses and property loans. Litigation finance is also IF Isa eligible. Investors can divide their £20,000 Isa limit across a stocks and shares Isa, cash Isa and IF Isa in the same tax year.
Proponents argue that IF Isas can be used as a diversification tool, but there is a risk that borrowers can default on their loan repayments. As investors usually have to lock up their cash for a set period, liquidity is another concern.
“Some of the larger peer to peer platforms offer relatively quick access to capital in normal market conditions,” says Guy Tolhurst, chief executive of Indegate Group. “But this is never guaranteed and is not the case everywhere.”
A troubled year
Investors cannot have failed to notice negative headlines in the past year.
Lendy, a high profile peer-to-peer platform offering returns as high as 12 per cent, collapsed last May owing 9,000 investors £152m, equivalent to 93p for every pound invested.
FundingSecure, which had offered P2P loans against art works and classic cars, collapsed last October. Landbay, which offered investors exposure to portfolios of buy-to-let mortgages, closed its doors to retail investors in December.
Even Funding Circle, one of the largest peer-to-peer lenders, has seen its share price fall by about 80 per cent since its 2018 flotation on the London Stock Exchange, highlighting uncertainty about the sector’s future viability.
Many financial experts worry about the prospects for investors who don’t understand the risks.
“I don’t go near peer-to-peer,” says Holly Mackay, founder of consumer website Boring Money. “The risks are hugely misunderstood and poorly explained. I see a car crash ahead for some retail investors.”
Under FCA rules introduced in December, investment platforms must now test potential investors on their understanding of the risks involved. Platforms such as Funding Circle embed the test inside a short educational module when investors open an account. If an investor fails the test, they can continue to retake it until they pass.
Investors have to identify what type of investor they are (“sophisticated” or “everyday”). If they have a net worth below a certain threshold, they are expected to self-regulate that they will not invest more than 10 per cent of their net investable assets in peer-to-peer loans, though this restriction is not enforceable by the platforms or the FCA.
“For most, P2P should only be for a small proportion of a portfolio which should be far more heavily focused on other assets such as equities, fixed interest and property and in cash savings accounts which are protected by the Financial Services Compensation Scheme,” says Patrick Connolly, a chartered financial planner at adviser Chase de Vere.
He added: “We don’t recommend the IF Isa to our clients.”
Yet P2P lending platforms say they are optimistic about the future, as the “bad apples” have failed and left the market. “The ones that were going to go wrong went wrong last year, and it was a big clear out,” says Frazer Fearnhead of the House Crowd, a property P2P platform.
“People have tightened up lending procedures over the past two years. We see the industry stabilising over the course of the next year, rebuilding investor confidence.”
“It might not feel like it, given the number of negative headlines, but we’re starting to see this nascent sector starting to grow up properly,” adds Mr Taylor from Octopus Choice.
Today, more than 30 FCA authorised P2P platforms offer IF Isas. Investors looking to pick a provider should consider how experienced the business is in the sector in which it is making loans, and how their loan book has performed over time.
“If the platform has a large amount of loan repayments overdue or in default, this could be a sign of poor underwriting standards,” says Mr Tolhurst.
“Not all IF Isas are the same,” says Sarah Coles, personal finance analyst at Hargreaves Lansdown. “They range from companies that let you make a single high-risk loan to a small company, to those that spread your cash out among thousands of individual borrowers.”