Frazer Fearnhead, founder and chief executive of The House Crowd, explains what investors should look for when choosing their tax-efficient product
SINCE THE INCEPTION of the Innovative Finance ISA (IFISA) in 2016, the number and variations of products available have proliferated. So how should investors choose between them? Most IFISAs fall into one of three main categories: consumer loans, small business loans and property loans.
Consumer loan IFISAs typically offer returns of around four or five per cent per annum on unsecured loans and some platforms allow investment from just £10. Business loan IFISAs generally offer returns in the six to seven per cent range, with minimum investments typically starting at just £100.
Property-backed IFISAs democratise investing in property and are suitable for individuals who want to avoid the hassle and associated costs of investing in bricks and mortar. Minimum investments typically start at £1,000. Interest rates are typically higher than other loan types, often ranging between eight and 10 per cent per annum on self-selected investments and five to eight per cent on a diverse portfolio.
How comfortable are you with risk?
It is vital that investors understand that the rates quoted are not guaranteed. These are investment ISAs and they are not covered by the Financial Services Compensation Scheme £85,000 guarantee. IFISAs which incorporate P2P property-backed loans offer potentially good returns with the downside protection based on the value of the property.
However, there are still risks. A property loan can go wrong through a mistake by a valuer, a mistake in securing the asset or through fraud. It is therefore important to choose a level of risk you are comfortable with. Generally, the higher the target rate, the bigger the risk that loans may run into trouble with late payments or defaults.
How diversified are your investments?
Diversification is a critical factor in mitigating risk. While we offer both auto-invest and self-select products within The House Crowd’s standard account, we made the decision purely to allow auto-invest products within our IFISA wrapper. We decided that we would enforce a degree of diversification for ISA investments, so that any potential losses can be mitigated by above-target returns received on other loans in the portfolio.
Is your money working for you 365 days a year? Self-select products may offer higher target rates, but chances are there will be some downtime between investments where your money will not be earning interest and this will reduce your overall return.
In contrast, with an auto-invest product, such as our IFISA, it’s working for you 365 days a year. Furthermore, you receive regular interest which can be rolled up, so, your overall return is likely to be better in auto-invest than self-select, even before taking the tax-free consideration into account.
Does the ISA enable you to compound your returns?
Compounding, as every investor knows, is essential for maximising long-term returns and an auto-invest product does that best with interest paid twice a year. If it is rolled up – especially in a tax-free wrapper – it will massively increase the size of your investment pot over a 25-year period. Some acceptance of risk is required if you want to build up your capital.
IFISAs offer attractive returns without the volatility of the stock market but the target rates are not guaranteed. You should ensure your investments are diversified across a pool of different loans. In order to mitigate risk further you should either ensure you have the security of a property-backed loan or check that there is some sort of provision fund to cover defaulting loans.