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When interest rates are low, investors look away from traditional savings accounts to find returns that beat inflation.

Since the Bank of England cut the base interest rate to 0.50% in March 2009, savings rates have been decimated. In 2007, the average savings rate was 5.5%. Now the best rate for an easy-access cash savings account is 1.3%.

There are no easy-access cash savings accounts or cash ISAs that match the consumer price index (CPI) rate of inflation – 2.5% for March 2018. A few current accounts pay above 2.5% but only on limited balances with strict qualifying rules. Even the highest paying five-year fixed rate savings bond, at 2.65%, only just beats inflation.

The hunt for real returns has led investors towards riskier assets like stocks and shares ISAs, which are prone to stock market volatility, buy-to-let property, and even cryptocurrencies with unstable valuations.

Another option is direct lending through an Innovative Finance ISA (IFISA), which connects borrowers and lenders. It offers higher potential returns of 5-8%, but at a higher level of risk compared to more conventional savings products.

What is an IFISA?

Launched in April 2016, IFISAs are linked to peer-to-peer (P2P) lending activities that enable small businesses to access finance, bypassing banks.

IFISAs allow individuals to invest some or all of their annual ISA allowance – £20,000 for 2018-19 – through P2P lending and receive tax-free interest at a higher rate than cash ISAs and savings accounts.

Higher potential returns are available because P2P lending partially cuts out the “middle man” – the bank – reducing overheads, leaving more profit for investors.

Cash ISAs offer fixed returns, so investors cannot lose money. The first £85,000, like deposits in UK banks or building societies, is protected under the Financial Services Compensation Scheme (FSCS).

The first £50,000 of a stocks and shares ISA is protected if the provider is a member of the FSCS. IFISAs are not protected under FSCS, so if the provider goes bust you could lose your money.

What are the rules?

With IFISAs investors lend to individuals and businesses through P2P lending platforms that are regulated by the Financial Conduct Authority (FCA). Property loans are permitted but equity-based investing isn’t.

All UK taxpayers over 18 have an annual ISA allowance. You can invest the whole allowance in an IFISA or split it between an IFISA and other types of ISA. You can only invest in one IFISA each year but can invest in different ones in subsequent years.

As with all ISAs, your annual allowance can’t be rolled over to the next tax year, so use it or lose it.

What are the expected returns?

Experts recommend investing in an IFISA as part of a balanced portfolio; they’re riskier assets and not protected by the FSCS, so they should constitute only part of your savings.

Most P2P platforms advertise returns from IFISAs of around 5-8%, but there are variations. Generally, the lower the rate the lower the risk.

ISA transfers

You can transfer in existing ISA balances from cash ISAs or stocks and shares ISAs into an IFISA. For current tax year transfers, you must transfer the full amount.

You can transfer in any amount from ISAs from previous tax years, without affecting your current year ISA allowance.

To transfer, you must complete a transfer form with the IFISA provider you want to switch to. Remember, don’t withdraw and re-invest as it could affect your ISA allowance.

How to invest in an IFISA

Investing through an IFISA should involve a medium-term commitment of more than one year, to allow for performance fluctuations and time to build a diversified portfolio.

Diversifying by investing in a range of platforms and asset types over years helps you manage risk and allocate your investment portfolio efficiently.

IFISA provider numbers are growing and most operate within the P2P arena. The biggest UK players are Zopa, Funding Circle, Ratesetter and Lending Crowd.

They generally have a good record on protecting investors’ funds – though in 2017, Ratesetter had to plug a £9m gap for a failed loan-deal and Zopa cut customer return rates after a rise in consumer bad debts.

However, with many new players entering the market without much history, be cautious and study the platform and how it assesses borrowers.

Flexible ISA rules introduced in April 2016 allow cash ISA investors to withdraw and re-invest in the same tax year, penalty-free without affecting their allowance or its tax-free status.

P2P lenders don’t have to offer flexible ISAs – some do, others don’t – so check the terms before investing if you want to withdraw and replace funds in the same tax year.

Most IFISAs don’t charge for using the platform but some charge for certain services, like transferring funds from their tax-free wrapper, so check the small print. Minimum IFISA investments range from £1 to £5,000.

IFISA risk factors

The IFISA market is small but growing. HMRC said 2,000 IFISA’s were opened in 2016-17, but new providers have launched products in 2017-18, so figures will be higher.

Potential providers must be fully FCA-authorised, so be sure to check for their FCA credentials before you jump in.

The wider P2P sector has not been tested by a recession but, in theory, lenders are protected as funds are ring-fenced and can’t be used for anything other than the purpose lent for, limiting potential losses.

However, the P2P market and IFISA sub sector is developing and not all growth aspects can be predicted. There’s likely to be some disruption and casualties as the market shakes out – but so far no individual investors have lost money and most providers have contingency funds to protect investors from defaults.

Earlier this year, P2P platform Collateral fell into administration. This led investors in other platforms to question how they could recoup funds. Other platforms assuaged concerns by informing investors that unlike Collateral, they’re fully FCA-authorised, hold client money separately and have a “living will” to protect investors if their business fails.

Even though Collateral wasn’t authorised by the FCA, the FCA intervened in the administration process to protect investors.

What’s your attitude to risk?

Before investing, establish your aims and attitude towards risk. Are you investing to grow capital, to provide an income or a combination of both? Decide how long to invest for, your investment target and, realistically, how long it will take to reach it.

If you’re approaching retirement, capital preservation is important and investing in an IFISA might not be suitable now.

If you’re younger and have longer to ride the ups and downs of the market, then an IFISA may be a good option – just be aware that you can lose money as well as make it.

IFISA: Pros and cons

You must balance the potential benefits of higher returns against higher investment risk. Some platforms have higher standards than others for investing, managing credit and customer service.

Because the IFISA market is new, it has relatively low barriers to entry. This has benefits and drawbacks: it encourages innovation and means there’s more choice, but there’s also the potential for more dud companies to sneak onto the market. Choosing the right platform to invest through could become difficult.

Also, IFISAs invest in different loan categories so it’s difficult to predict how a loan in an unusual class will perform, especially without prior experience or past performance to analyse.

Another drawback is ‘cash drag’. Your money only earns for you when it’s lent out, so interest and capital repayments need to be re-invested promptly. Some providers re-invest funds automatically.

What’s the verdict?

If you’re interested in IFISAs, start investing a small proportion of your overall funds and test it out at the riskier end of your portfolio and monitor progress, but be cautious because it’s yet to be tested by an economic downturn and there’s little protection if things go wrong.

Now read: How to choose a savings account or learn more about ISAs