Savers are being urged to think twice before ploughing cash into tempting Isa deals that promise returns as high as 6.5 per cent.
These headline-grabbing rates will appeal to interest-starved savers looking to use their £20,000 tax-free Isa allowance before the end of the tax year on April 5.
But experts warn that these deals are far riskier than a normal savings account.
Risk: Innovative finances Isas are offered by so-called peer-to-peer lenders which, through their websites, match savers and borrowers — both individuals and small businesses
Known as innovative finances Isas, they were first launched three years ago. They are offered by so-called peer-to-peer lenders which, through their websites, match savers and borrowers — both individuals and small businesses.
By cutting out the middle-man — the banks — borrowers pay less, while you as the lender earn more. The take-up has been slow with just 36,000 accounts opened in the first two years.
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HOW THIS IS MONEY CAN HELP
Best savings rates: Cash Isas, fixed rate Isas, regular savings Isas
Over the same period savers opened more than 16 million of the better-known cash Isa.
For savers, innovative finance Isa rates are far higher than the top 2.3 per cent Isa rate you can earn by tying your cash up for five years with Coventry BS or Shawbrook Bank.
But you are taking much more risk. First, you might not earn the advertised rate because the borrower might find they cannot afford to pay the interest promised. You also risk your capital because they could default on the loan.
When you save with a regular bank or building society, up to £85,000 of your money is covered by the UK Financial Services Compensation Scheme if the firm goes bust. However, with innovative Isas, you do not benefit from the same cover.
If you are still tempted to invest some cash in this type of account, spread it around lots of different lenders so if one fails you will not be as badly hit. As a rule-of-thumb, the higher the interest rate offered, the greater the risk you are taking.
RateSetter, Funding Circle and Zopa, the three largest peer-to-peer lending sites, offer returns of between 4.5 per cent and 6 per cent, while Lending Works has a higher 6.5 per cent.
Your final rate depends on the level of risk you take and how long you agree to tie your money up for.
Loans to small businesses are usually deemed riskier than those made to individuals, so rates will be higher. If you want to get your money out before the end of the term you will be charged an exit fee.
You will also have to wait for the website to find another lender to take over your loans.
Patrick Connolly from independent financial advisers Chase de Vere says: ‘Innovative finance Isas are not like savings accounts as you are relying on the borrower to actually pay the interest and repay the capital.
‘We don’t use this type of Isa. Instead, we mix and match shares, bonds and cash to get a better return than you can earn on just cash.’
Danny Cox, from independent advisers Hargreaves Lansdown, says: ‘Don’t put more than 5 per cent or 10 per cent of your money in these plans and use a ready-made product which spreads your risk among lenders.’