Innovative Finance ISA: be afraid, be very afraid

The Innovative Finance ISA was launched in April, but you probably haven't given it much thought since then -- and with good reason, because there are only a handful to choose from. However, that is about to change.

Meet your peers

You're going to hear a lot more about the Innovative Finance ISA, with City regulator the Financial Conduct Authority (FCA) now processing more than 80 applications, many of which should be authorised from next month. They will pay rates ranging from 5% to 15% a year, in a bid to seduce savers who are struggling to get just 1%.

Here's some advice to anyone who is tempted: approach with caution.

The Innovative Finance ISA, or IFISA, allows savers using peer-to-peer (P2P) lending platforms to take their returns free of income tax. Platforms match ordinary savers with individuals and businesses who want to borrow money, cutting out the banking middlemen to give both parties a better rate.

Zopa on a rope

Zopa is probably the best known. It has attracted more than £2.14bn, from 63,000 individuals, since launch in 2005, and currently offers between 2.9% and 6.1% a year, which varies according to the term and risks you are willing to take. Ratesetter, which pays up to 4.1%, has attracted almost £1.8bn while fellow pioneer Funding Circle tops £2.1bn.

All three will be launching an Innovative Finance ISA soon. Of the few already out there, Lending Works targets returns of 3.6 per cent over three years and 4.5 per cent over five. CrowdStacker Loans targets between 5.43% and 7%, while Crowd2Fund Loans estimates a dizzying 8.7%.

Start me up

This means you could get more than 10 times the rate on the average cash ISA, which is currently a measly 0.82%, according to Moneyfacts.co.uk. Hard-up savers keen to chance their luck need to understand exactly what they are getting into.

Take Crowd2Fund. Like many P2P platforms, it lends to growing businesses looking to expand, which is a sector with a high failure rate. Current offerings include a cookery school, digital printing company, outdoor toy business and an alloy wheel refurbishment business. One company, Ethos Technology, offers 13% a year. Even with due diligence, this is like spinning a roulette wheel.

Taking stock

The targeted income on P2P sites is not guaranteed, and neither is your capital. Sites are regulated by the FCA, but you have no protection under the Financial Services Compensation Scheme. Stocks and shares are also risky, but investors have had years to absorb the dangers. They face a rapid learning curve with the Innovative Finance ISA, and could slip up. Also, stock market investors aren't seduced by talk of double-digit annual returns, which could mislead the unsuspecting.

Everybody knows there are no guarantees with the stock market, only the historical evidence that, over the longer run, it outpaces every rival form of investing. By all means take a spin on P2P, but only risk a small part of your portfolio. The majority should still be spread across a balanced portfolio of stocks and shares, across diversified mix of companies, sectors and regions for added safety. That way you should have a lot less to fear.

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Harvey Jones has no position in any shares mentioned. The Motley Fool UK has no position in any shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.