ISAs – those popular tax wrappers for savvy savers – have been out of fashion with investors for several years thanks to rock-bottom yields and a lack of competition in the savings market.

Cash ISAs in particular were previously seen as a safe haven for your money, because they do not put your capital at risk and any interest you earn will not be subject to tax, up to the annual limit. They present investors with a no-risk alternative to stocks and shares ISAs that are potentially more volatile and could therefore leave you with less than you initially put in.

But now that interest rates are sitting below inflation1, those who are keeping their hard-earned cash in Cash ISAs are, in fact, making next to nothing, and may even be finding that the value of their money is slowly being eroded away on an annual basis.

So, is there another way to use your ISA allowance without exposing yourself to an unpredictable stock market and still getting inflation-beating returns?

Well, recent consumer trends are proving that the Innovative Finance ISA is shaking up the tax-free investment space 2 and providing a middle ground for investors who want to achieve better returns without worrying about how market conditions might immediately affect their investments. Although it’s important to remember that your capital is still at risk if you deposit your money into an Innovative Finance ISA and as Octopus Choice is concentrated in the property market your investment could be affected by market conditions.

What is an Innovative Finance ISA?

The Innovative Finance ISA (IFISA) was introduced in April 2016.

It’s a vehicle that allows those who are investing in peer to peer (P2P) loans to receive tax-free interest up to the annual limit.

An Innovative Finance ISA effectively ring-fences any gains from P2P investments from tax. You can pay up to £20,000 into this ISA in any tax year (as long as you haven’t paid into any other ISAs that year; to get more clarification around your ISA allowance, click here. Any interest you earn in this investment will be exempt from tax (although your tax treatment does depend on your individual circumstances and may be subject to change).

It would be impossible for us to directly compare the rates between a Cash ISA and an IFISA, as what sits within these wrappers is distinctively different; the former is a savings product, and the latter an investment product. However, IFISAs are more likely to generate inflation-busting gains for investors who are willing to place their capital at risk.

What types of P2P loans are available to investors in an IFISA?

There is a plethora of P2P lending options out there, and it’s important to review what’s on offer from the market before settling on an investment product. Products can sit in the same ISA wrapper, but can offer varying levels of risks and returns.

You can choose to place your money into secured and unsecured loans. As you would expect, secured loans are backed by an asset, which means that you may be able to recoup some or all of your capital through the sale of the asset, should the borrower default on the loan. Unsecured loans aren’t linked to any assets whatsoever, and therefore do not come with as much security for the lender.

So, while unsecured loans may offer higher rates of return, they may place your money at a higher risk.

Secured loans – such as those placed against properties, for example – are, on paper, a better bet for more risk-averse investors.

Are IFISAs proving to be popular?

We’d certainly say so! According to HMRC’s Individual Savings Account (ISA) Statistics from August 2018, the amount held in IFISAs has increased significantly since they were initially introduced several years ago.

Amount held in IFISAs3
Amount held in IFISAs

Also, of note, at £9,355 IFISAs now have the second largest average deposit size after stocks and shares ISAs.

Average deposit size per ISA3
Average deposit size per ISA

As a result, more P2P providers have been entering the market to meet this newfound demand. Bigger names (such as Octopus) are now facilitating P2P investments, and experts have predicted that 400,000 investors will enter the peer to peer sector by 2022 thanks to escalating interest (source: Intelligent Partnership, Peer to Peer Lending Report 2017, February 2017).

When to consider this type of ISA

If you are a UK peer to peer investor over the age of 18 who is enjoying higher returns from a more diversified P2P portfolio, you might consider placing your funds into an Innovative Finance ISA. Doing so could reduce your tax burden in the longer term. Remember, however, that your tax treatment will depend on your circumstances and that the annual limit applies across all ISA types.

Are there any risks involved in using an IFISA?

We must stress again that interest rates on IFISAs cannot be compared like-for-like with those on offer from Cash ISAs for a number of reasons – the main one being that peer to peer lending is not currently protected by the Financial Services Compensation Scheme (FSCS). An IFISA is not a risk-free product, although you will not have to pay any tax on any interest you earn, up to the annual limit, you may still get back less than you put in.

It’s up to the investor to assess the risks involved and decide if they are willing to chase higher potential returns for the sake of a less security. Alternatively, you may wish to seek professional advice from your financial adviser. To gain a better understanding of the risks involved, click here.

In summary

Cash ISAs still have an important part to play as part of a balanced investment portfolio - but investors are increasingly turning to IFISAs to try help them accelerate their returns. This is illustrated by the fact that, according to statistics released from HMRC in August last year, 2017 saw the market value of funds held in stock and shares and Innovative Finance ISAs overtake the funds held in Cash ISAs.

Market value of funds by ISA type3
Market value of funds by ISA type

Innovative Finance ISAs are simultaneously addressing the shift towards peer to peer lending and offering customers more attractive yields while negating some of the volatility of the stock market. They’re a viable option for those who are venturing into the P2P lending space – and, as the concept of this type of lending becomes more mainstream, we’re certain that IFISAs will continue to grow in popularity in the months and years to come.

1 Based on the inflation rate (ONS, 2nd February 2019) and Moneyfacts top 5 one-year fixed rate Cash ISAs (2nd February 2019).
2 - P2P lenders bullish about 2019 IFISA boost (1st March 2019)
3 Individual Savings Account (ISA) Statistics (August 2018), HM Revenue and Customs