How risky are IFISAs?
When it comes to investing, there are numerous questions that need to be asked, and lots of things which need to be properly understood before committing your hard-earned money. But the most important criterion which you need to feel satisfied with is that the probable level of reward exceeds the risk you're taking on.
In terms of rewards, the Innovative Finance ISA (IFISA) is carving out an established reputation for itself, with headline rates of between 5 to 10 per cent for investors, and reliable returns. The fact that these returns can be shielded from tax by virtue of an ISA wrapper only adds to the lucrative appeal of this investment type.
However, before jumping in head first, it's important to have a clear understanding of the process, and, crucially, the level of risk involved.
Background to IFISAs
An IFISA is a relatively new category of ISA which enables you to allocate your tax-free ISA allowance towards peer-to-peer (P2P) lending. Since the launch of the first platform in the UK in 2005, P2P has grown at a rapid rate (the sector has now facilitated more than £10bn in loans), and, since April 2016, many peer-to-peer platforms have been eligible to offer investors the opportunity to protect repayments received on their loans from tax within this standalone class of ISA.
What are the different types of IFISA?
Although the IFISA has not been created exclusively for P2P, and is instead the preserve of 'loan-based crowdfunding', P2P is the dominant sector within this category. You can also hold debt-based securities within an IFISA, but, as things stand, almost all IFISAs are facilitated by peer-to-peer platforms.
Nevertheless, within the P2P industry there is a wide range of loan types. Some platforms operate personal loans, while other types of lending include business loans, secured loans, mortgage-backed lending, invoice finance, retail finance and more. Such a diverse set of investment options means that risk profiles vary from platform to platform - as do the level of potential returns.
IFISAs: understanding the risks
The biggest risk of all is that the borrower(s) to whom you are lending default on their loan(s). Neither your capital nor returns are guaranteed by the platform. Additionally, there is the risk that the platform can go bust, with unknown consequences for your loans. There is no cover from the Financial Services Compensation Scheme (FSCS) in either case.
Yet while it is important to understand such risks, it's equally crucial to consider what measures platforms take to mitigate them. At Lending Works, for example, we have in place the Lending Works Shield, which offers protection to lenders:
Diversification: Your investment is spread across many loans, therefore reducing your exposure if any single borrower defaults.
Contingency Fund: Topped up by a fee charged to borrowers, this segregated fund steps in to cover any arrears and defaults to ensure you receive your repayments in full, on time.
The above is underpinned by meticulous credit underwriting, and robust credit models to ensure that only creditworthy borrowers are approved for loans. Additionally, Lending Works also has a back-up service in place with a third party, which, in the unlikely event that our platform ceases trading, will take over day-to-day operations to ensure that our loan book is unwound in an orderly manner and that all outstanding loans reach maturity.
Some of the above measures are commonplace among P2P platforms, but by no means all of them. As such, it is important to do your research before opening an IFISA, and ensure that your investment will be in safe hands.
IFISA risks: your questions answered
How are IFISAs regulated?
Peer-to-peer lending platforms must have full authorisation from the Financial Conduct Authority (FCA) in order to provide IFISAs to their customers. This is to ensure that adequate protections are in place for customers; primarily lenders/investors, but also borrowers.
FCA authorisation also ensures firms adhere to common rules, and that all services are provided in a clear, fair and not-misleading manner to customers. There are additional regulations in place regarding the handling of client money, and complaints procedures.
As an additional layer of regulation, eight UK P2P platforms comprise the Peer-to-Peer Finance Association (P2PFA), a self-regulatory body whose strict set of Operating Principles ensures that members promote high standards of conduct, consumer protection and transparency.
Are IFISAs FSCS protected?
No. Unlike UK savings accounts (and certain regulated investments), where you are protected to the tune of £85,000 per institution, there is no cover on loss of capital afforded by the FSCS, nor if the platform goes under.
Which IFISAs have the best track record?
As mentioned above, the IFISA officially went live in April 2016, but many leading providers only launched their product well after this. As such, there isn't much data to work with relating specifically to IFISAs. However, peer-to-peer platforms have been around much longer, and, given that IFISAs are almost-exclusively offered by these platforms, researching performance within P2P provides the basis for a valid comparison.
Headline rates is one metric to look at, but a more important one is the real returns delivered by a platform after borrower defaults. At Lending Works, which launched at the start of 2014, lenders have so far received every penny due to them, when they have expected it. This is true of some other platforms too. In fact, among most reputable P2P platforms, lenders have yet to experience any capital losses, and, where returns have fallen below expectation, these usually tend to be cushioned by higher headline rates.
How do I assess risk among IFISA providers?
There are some key risk indicators to consider when choosing an IFISA provider. Here is a handy checklist of 10 questions which you should seek answers to:
It's worth noting that P2PFA members are required to display all historical performance data on their websites, and avail their loan book too. Such transparency gives you the opportunity to conduct detailed analysis, and make an informed decision when choosing an IFISA provider.
Will IFISAs survive a recession?
It's important to factor in all stages of the economic cycle when analysing a prospective investment, particularly within an industry such as P2P lending, which could be sensitive to rising default rates during a downturn.
Yet to some extent, P2P lending has already survived a recession. The first platform opened its doors three years before the financial crisis began to buffet the economy. During the worst of the recession, losses were well contained, and average returns remained robust - in the region of 2 to 3 per cent, in fact.
This is where loan underwriting plays a vital role. Affordability criteria within credit modelling should take into account the potential for unemployment when a borrower applies for a loan. While a platform’s credit underwriting process is not something that can be tangibly known by a customer, there are some key indicators which can give you an idea.
Do providers leverage IFISA investments?
No. Unlike investment banks, IFISA providers allocate money invested by lenders to borrowers on a pound-to-pound basis. No money is therefore created or leveraged, nor is there any form of fractional reserve banking. Such a simple model means there is less exposure in the event of a downturn, and reduced risk to customers (and the wider economy) as a result.
What other risks should I be aware of?
The level of accessibility to your IFISA investment should be taken into account. If you wish to transfer or withdraw your money, it’s important that you are familiar with the process, timings and fees involved.
Other risks to consider are fraud and cybercrime. There is no FSCS protection in this respect either, and, while many platforms will compensate you in most cases, there are circumstances where they will be under no legal obligation to do so. It’s therefore imperative that you take note of the platform’s policy on fraud and cybercrime, the safeguards they have in place, and remain vigilant yourself at all times.
Are IFISAs worth the risk?
Again, it must be reiterated that IFISA risk profiles vary from platform to platform. But, as a rule, IFISAs are widely accepted to be a midpoint in terms of risk and reward between cash ISAs and stocks & shares ISAs. In fact, most experts would agree that P2P lending is a relatively low-risk investment. Unlike putting money into the stock market, the value of your IFISA doesn’t go up or down, and, rather than experiencing volatility, investors have enjoyed steady returns from IFISAs to date.
And while your money isn’t guaranteed in the way it would be if you put it in the bank, the reality is that almost all cash ISAs pay returns below the rate of inflation. So, in the absence of risk, your money perpetually loses value in real terms.
Of course, each individual investor is different in terms of preference and risk propensity, and doing your homework is important. But the combination of predictable, inflation-beating returns and a simple sign-up process means the IFISA is building an impressive track record, and it makes a strong case for inclusion within your ISA portfolio.
Our website offers information about saving, investing, tax and other financial matters, but not personal advice. If you're not sure whether peer-to-peer lending is right for you, please seek independent financial advice, and if you decide to invest with Lending Works, please read our Key Lender Information PDF first.
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