The truth about Innovative Finance ISAs

What exactly IS an Innovative Finance ISA? This ISA season we look at just what's in these so-called cash alternatives. easyMoney claims its Innovative Finance ISA can offer ‘inflation-busting interest rates’ because it has ‘no costly branch networks to maintain’ and doesn’t need to worry about the ‘significant maintenance expenses of out-dated computer systems’.

This is nonsense. In the end, it's debt, it's not protected by the Financial Services Compensation Scheme and you're exposed to more risk than you think.

- "For investors frustrated by the poor returns on cash ISAs but also concerned about the current volatility of the stock market, an Innovative Finance ISA could be an ideal solution."

Lending Works

- "The easyMoney Innovative Finance ISA is aimed at investors across the UK who have had enough of the poor interest rates offered by cash ISAs and are nervous about the potential volatility of most Stocks & Shares ISAs."

easyMoney

This is how the innovative finance industry sells itself – a gentle middle ground between the volatility of stock markets and the security of cash. Even better, many sell themselves on giving one in the eye to the big guys, to those greedy banks and investment managers.

And it seems that people like what the innovative finance industry is saying. Statistics published in August 2018 by HMRC, show the amount of money invested in Innovative Finance ISAs rose from £36m to £290m in just a year.

Andrew de Candole, CEO of easyMoney said:

- "Financial services in the UK are in desperate need of a shake-up. Like European air travel 23 years ago, the ISA market is crying out for someone to give everyday investors more for their money."

We wouldn’t necessarily dispute that the financial services industry needs a bit of a shake-up. For some time, providers have acted as if no-one other than my Dad would ever contemplate buying a financial product. However, we are also distinctly wary about overblown claims – and this is why we worry about some of these innovative finance ISAs.

Let’s look in a little more detail.

As we see it, there are a number of important things to note:

• They are not cash. They are not even close to cash.

easyMoney claims its ISA can offer these ‘inflation-busting interest rates’ because it has ‘no costly branch networks to maintain’ and doesn’t need to worry about the ‘significant maintenance expenses of out-dated computer systems’.

This is nonsense. It can offer these ‘inflation-busting interest rates’ because the product isn’t invested in cash.

Investors are taking a risk that they can lose capital, which isn’t the case with a cash savings account.

• The income comes from loan repayments, not ‘interest’ as such

With an innovative finance ISA, the provider takes your money and lends it to other people. These may be individuals – Zopa, RateSetter – or it may be companies – FundingCircle, ThinCats – or, as in easyMoney’s case, it may be property developers. The income you receive is dependent on those people making those repayments. People tend to be better than companies at repaying loans, but Zopa still estimates a default rate of close to 5% for its 2018 loan book. That means almost 5% of the loans it makes aren’t paid back.

Some providers have measures in place to help if those people don’t make the repayments. EasyMoney has some charge over the property, Lending Works has a slush fund. Either way, the money you receive is not guaranteed.

• The rates aren’t always very good for the risk you’re taking

In the stock market, the value of the stocks you own can go down, as Carillion shareholders are about to find out. However, if you had your money in a FTSE 100 tracker (which gives you access to a range of the UK’s largest companies), the most your investment has ever dropped is 50%. And that was in an ‘end-of-the-world-as-we-know-it’ scenario - the Global Financial Crisis. Oh, and if you’d stayed invested, you’d have recovered your money and then some by now and been paid dividends while you were waiting.

There’s also quite a big upside - If you’d invested in the average UK All Companies fund over the past five years, you’d have made 43.8%. The best fund would have made you 133%. You may also have received dividends of 3-4%.

With peer to peer you get an interest rate, but that’s it. You can’t get more and you won’t get all your money back if someone defaults on their loan repayments. If I were lending to a property developer, I think I’d like a little more than a 4-5% interest rate to take that risk. N.b. RateSetter pays over 7%, which seems much more realistic compensation for the risks taken.

• Some are distinctly better than others

With Lending Works, it is made very clear that capital is at risk. There are credit checks in place for borrowers to ensure creditworthiness and investors will always be diversified across a large number of loans to minimise the impact of any one default. To date, it says, ‘every payment of capital and interest has been paid to lenders on time since we launched in 2014’. For this, investors get 6% p.a. over five years or 4.5% p.a. over three years in the Lending Works ISA.

As of August 2018, the easyMoney ISA 'pays up to 7.28%' interest rate and claims to ‘lend directly to property professionals, secured by UK property’. This could literally be anyone. It could be a half-built scheme on reclaimed land in Greenford. You just have to rely on their property guy. Again I say, I’d like a little more than 4% to take that risk.

• You aren’t covered by the Financial Services Compensation Scheme

The FSCS covers you for up to £85,000 if your financial services provider goes bust. It was introduced when people were all nervous about the banks to make sure they didn’t withdraw their money. This is important protection, particularly when you’re investing with smaller businesses and companies. https://www.fscs.org.uk.

Peer to peer lending is now regulated, but it still doesn’t have FSCS protection.

The verdict? treat with caution.

You can ask us any questions about Innovative Finance ISAs (or anything else) this ISA season here.

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