Where does P2P fit in an investment strategy?

From 6 April 2016 the choice of ISA investments is expanding with the addition of the P2P ISA, allowing investors to benefit from tax-free returns from peer-to-peer lending.

So with more investments becoming available, which do you choose?

We have a look at how much risk is involved in different ISA investments to help you decide how to use your annual £15,240 ISA allowance.

Cash ISA

Cash ISAs are the safest option, carrying the same level of risk as a taxable savings account. Your money is protected by the Financial Services Compensation Scheme which pays up to £75,000 compensation per person for financial loss.

But despite the security of cash ISAs, they may be an unattractive option for some investors as they offer low returns. With the Bank of England base rate set at 0.5% since 2009, cash ISAs typically offer rates below 2%.

Peer-to-peer lending

Peer-to-peer lending involves lending your money to borrowers, typically small businesses or consumers, through an online platform. Peer-to-peer loans will be available through a P2P ISA from April 6th this year. The level of risk depends on who you lend to; platforms rate borrowers according to how safe they are to lend to and provide investors information on borrowers’ financial status and how they intend to use the loan. This means you can choose your own level of risk and the return you want to achieve – lower risk borrowers come with lower returns while you can earn more by lending to higher risk borrowers.

While peer-to-peer lending is not covered by the Financial Services Compensation Scheme and there is the risk that a borrower could fail to repay back the loan, peer-to-peer lending can be a less risky option if you are fully aware of these risks and how to reduce them. Platforms advise investors to spread their money across many loans to reduce the risk of losing large amounts of money if borrowers default, and some platforms have funds in place to cover investor losses.

Bonds

Bonds do not have their own type of ISA, but you can invest in corporate and government bonds in a Stocks and Shares ISA, either through a managed fund or by selecting the bonds yourself.

Bonds vary in risk; government bonds are typically the safest but offer lower returns, while corporate bonds are higher in risk. Bonds are generally safer than shares as they pay a fixed rate of interest, despite being able to fall as well as rise in value or being at risk of defaults. Be careful to avoid ‘junk’ bonds – high yield but very high risk bonds with low credit ratings – if you are looking for secure investments.

Debt securities

Debt securities or ‘mini-bonds’ are when individuals lend money directly to businesses for a fixed term and earn regular interest payments. Some crowdfunding platforms issue mini-bonds to investors, and these are set to be included in the Innovative Finance ISA from Autumn 2016.

The risks with debt securities are greater than that of listed bonds as regulations are less strict. Debt securities are not covered by the Financial Services Compensation Scheme, and they cannot be traded so must be held until the end of the term. However, the returns are greater than from a cash ISA and many other bank savings accounts.

Shares

The Stocks and Shares ISA allows you to buy shares in individual companies in return for dividends paid out to investors if the company makes a profit. Shares are typically a longer-term investment than cash ISAs and can deliver significantly higher returns, but are fairly high risk as stock market investments could fall in value and you may end up with less than the capital you invested.

However, the risk can be reduced by diversifying your investments – spreading them between shares in many different companies – which can help to protect your funds in the case of a company going bust.

Equity crowdfunding

Equity crowdfunding involves investing in shares of early stage companies which are not listed on the stock market through an online platform. Crowdfunding is not currently included in the list of ISA-available investments, but the government is consulting on whether to include it in the Innovative Finance ISA.

If equity crowdfunding was to be included in an ISA, it would be one of the higher risk investment options as early stage companies are much more likely to fail than established companies. Buying shares in young companies also means that you do not receive guaranteed regular returns and you are unlikely to receive any returns until you can sell your shares, making it a long term investment. However, as with peer-to-peer lending and buying shares on the stock market, you can reduce your risk by diversifying your investments.