The under-the-radar ISA which could boost cash returns and help you invest ethically

Billions flow into ISAs every year. But just £81m went into Innovative Finance ISAs (IF ISA) last year. This little-known ISA option is often overlooked, but it could mean you are missing out.

When it comes to ethical investing you could choose a cash ISA with an ethical bank or put an ESG fund in your stocks and shares ISA.

But this is an area where Innovative Finance ISAs can also be useful.

Often shortened to IF ISA, it allows you to lend money directly to businesses or individuals and earn tax-free interest in return. For some investors, that direct link between their money and a specific project is precisely the appeal – as you can support community projects, clean energy and social housing.

Introduced in 2016, Innovative Finance ISAs let savers use their annual £20,000 ISA allowance to invest in peer-to-peer loans and certain forms of debt-based crowdfunding.

Instead of depositing your money with a bank, you lend through an online platform. Borrowers then repay the loan with interest, and that interest is yours to keep free of income tax.

The number of people investing in IF ISAs is on the rise. In 2024, deposits rose by 46 per cent, according to CapitalRise. In the 2023–24 tax year, investors put £81m into Innovative Finance ISAs, according to HMRC data. On the up, then, but barely a dent compared with £69bn flowing into cash ISAs and £31bn into stocks and shares ISAs.

For IF ISAs the main attraction is the returns – they typically offer a slightly higher return than a cash savings account, around 5 per cent to 8 per cent depending on the loan. But you are taking more risk with your cash to get that return.

IF ISAs may look like a cash savings account on the surface but your money doesn’t have the same protections as cash in a bank – we’ll detail the risks further below.

Most IFISAs are used for peer-to-peer (P2P) lending. You lend your money directly to property developers, small businesses or consumers.

The platform matches lenders and borrowers and manages repayments, but you are effectively acting as the bank.

This is how banks traditionally make their money. They take your savings and lend it out, you then get a cut of the return as the interest paid on your savings. With P2P lending you are cutting out the bank and keeping all the interest for yourself. However, you also bear all the risk – if the borrower misses a repayment or defaults entirely you could lose money.

Outside of an IF ISA any interest from P2P loans counts towards your personal savings allowance.

Basic-rate taxpayers can earn up to £1,000 in savings interest before paying tax, higher-rate taxpayers get £500, and additional-rate taxpayers get nothing.

Within an IF ISA, all interest is tax-free regardless of how much you earn.

Unlike a cash ISA, IF ISAs are not covered by the Financial Services Compensation Scheme (FSCS).

So, if the person or business you lend your money to falls behind on their repayments you may not get your money back. Also, if the platform you hold your IF ISA with goes bust, you could also lose your money.

IF ISA providers do mitigate the risk of your borrowers not repaying you by holding large reserve funds to cover missed repayments. However, if a lot of debtors defaulted at the same time, the reserves may not be able to cover it all.

P2P loans and IF ISAs are considered a rung up the risk ladder than cash or most bonds. Whether you are willing to take that risk depends on your personal circumstances. So how much you have in savings and whether you are willing to risk losing some of your capital in return for higher returns.

Another attraction with Innovative Finance ISAs is the transparency around what you are investing in, which can make them a great ethical choice.

With many ethical or ESG funds, it is difficult to know exactly what companies you are investing in. This means you can’t be certain that your money is going to companies that match your own ethical stance.

With IF ISAs you have a clear view of who you are lending your money to. You might be supporting a solar farm, community housing project or charity.

For example, Triodos offers a range of IF ISA investments including a six-year loan to a charity for a special education needs college with a 7.75 per cent return. Or Ethex has a bond for renewable energy with a 6 per cent forecast return.

Innovative Finance ISAs remain a niche corner of the ISA market. But for investors who want their money to work hard something visible and tangible, they offer something few other ISAs can.

When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.