Targeting a £1m pot with an Innovative Finance ISA (IFISA)

And a steady tax free income for life before you retire – writes Jake Wombwell-Povey

The Innovative Finance ISA has recently been unveiled as the latest addition to the ISA family and, although it has had a slow start (name a financial product that hasn’t), it’s set to achieve lofty heights this year. It is forecast by market commentators that billions could be placed in this new type of ISA.

The killer question though is why? Why would investors invest in the IFISA, which may return less than stock markets, but carry greater risk than cash?

Well, with inflation outstripping bank rates, and with markets highly priced and volatile, the IFISA, which enables investors to invest in loans originated by digital lending platforms, can offer investors returns greater than those available on cash, but with less volatility and correlation to stocks and bonds.

The simple fact is that most investors won’t have previously invested in loans, so doing so adds a natural diversification to most portfolios.

But what can the IFISA really do for investors?

Well, the annual limits on ISAs (and before that PEPs) contributions has meant that becoming an ISA millionaire requires a combination of financial discipline, a strict savings regime…and steady returns.

‘within as little as a decade we all could be all be living in households of ISA millionaires’

But, within as little as a decade we all could be all be living in households of ISA millionaires, thanks to an explosion in the amount we can save each year in a tax-free ISA.

The new £20,000 annual ISA allowance means a couple can save £40,000 annually. Although this is still obviously a large amount of money, (especially once tax and non-discretionary expenses have been considered), it is enough to build a significant, £1m + nest egg for you and your partner over as little as 15 years.

George Osbourne kick started the ISA bonanza in 2010 and given the reduction in other available tax breaks they have become extremely generous in recent years and now stand at £20,000 per year per taxpayer. So a couple can save £40,000 a year together.

How can you potentially become an ISA millionaire just using Direct Lending to generate a steady, tax free income in just 15 years?

Well, if each partner in a couple invests the maximum of £20,000 per tax year, equating to £40,000 in total, then total contributions would equate to £600,000 in 15 years.

That may sound like a long time to invest, but with discipline the sum will grow quickly and the returns and gains will reward and encourage further investing and saving.

‘the pot would grow further to almost £1.1m in just over 15 years’

If all the interest income earned from these investments was then reinvested each year, at an assumed rate of 6.14% then the pot would grow further to almost £1.1m in just over 15 years. This is enough to generate a potential tax free income of almost £66,000 per year.

How you can use Direct Lending to help you reach your goal of becoming an ISA Millionaire:

• Try to invest as much as you can afford each year in the knowledge that returns grow much faster the longer they are invested – the effect of compounding of interest means that a small amount invested now quickly builds in later years.
• Reinvest all income and try and avoid withdrawing money from your ISA if at all possible. Remember, the aim is to build up a significant portfolio over the longer term that can provide capital or income at a later date. Don’t worry if in one tax year you cannot afford to put any more money in and equally you don’t need to worry if you need to withdraw some money. The benefit to ISAs over pensions is the flexibility to withdraw your funds at any time tax free.
• Choose established Direct Lending platforms that yield steady returns to invest your your money with.
• Investors are more likely to be consistently successful if they choose investments and platforms that consistently deliver returns, rather than offering high but volatile returns as it’s always more difficult to recover from a loss making position. Remember. Slow and steady wins the day.
• Avoid investing in riskier loans and the more exotic forms of lending. Whilst they may offer attractive returns, they a fraught with risks that need to be properly understood and often, when there are ample returns available elsewhere, this is may not be worth the risk. No doubt some will do well but others could lose you a substantial amount of money. Such companies are best left to specialists with expert knowledge.
• You should consider limiting your investment in loans and platforms that only invest in secured loans. It’s also important for platforms to have a good track record of recovering investors funds by liquidating these assets if things go wrong.
• You should only consider investing in platforms if you fully understand their underlying lending criteria and portfolio.
• Let profits run – if platforms are performing well for you, don’t feel the need to rebalance. Commentators would often suggest if a platform becomes particularly large it should be ‘top-sliced’ and profits taken.
• Have confidence in your judgment. Remember, you are investing for the long-term.

Remember, Direct Lending should form part of a balanced portfolio that is matched to your particular investment profile and goals, and within that strategy you should consider matching different asset classes to different tax wrappers.

For example when you are still accumulating wealth, pensions that are invested in for the longer term, are arguably more suited to higher risk equity investors, as in good years the returns are reinvested to grow and grow, whilst the long investment horizon gives plenty of time to recover from down years.

But this is also where the IFISA can come into its own for three primary reasons:

• Secured loans should generate steadier returns than other asset classes in a downturn because the assets backing the loans can be sold to ensure investors get at least some of their funds back. This means that, unlike equity markets that can suffer large drops in value, and can be driven more by sentiment that the realisable value of assets, secured loans should hold their value, and when aggregated, a whole portfolio’s, value. Whilst returns can’t be guaranteed, and capital is at risk as with any investment, investing in loans may provide investors with a steadier stream of income
• ISA funds are also accessible at any time with no tax penalties. However you should be aware that investments in loans are illiquid, (especially when compared to stock market investments) and investors should be prepared to have their funds tied up until the end of a loan term.
•  Investing in loans, (which are essentially, lots of little cash generating IOUs), will provide steady income and when held within an ISA, this income is tax free. This is unlike pensions where by funds are invested tax free, but withdrawn tax efficiently.