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How do Chit Funds work?

Introduction:

Back in 1900s when people needed money they would approach either

  • Friends
  • Money lenders or
  • Banks

Each one of the above has its disadvantages. Though friends would be willing to lend us money initially when we default, it would eventually affect our relationship with them. When it comes to money lenders, their interest rates are exorbitant. And we know how banks work(sigh!!).

This led to the establishment of a system where a person (called foreman) would collect some money every month from a group of people and the person who needs it collects the amount. This is a chit fund in simple terms.

chit fund is a type of rotating savings and credit association system practiced in India. Chit fund schemes may be organized by financial institutions, or informally among friends, relatives, or neighbors. In some variations of chit funds, the savings are for a specific purpose. Chit funds are often microfinance organizations.

Chit funds

How do chit funds work with example:

A chit fund comprises a group of members, called subscribers. The fund starts at an announced date and continues for the number of months equal to the number of subscribers. Each month, the subscribers put in their monthly installments into the pot. Then, an open auction determines the lowest sum a subscriber is willing to take that month. For example, if the monthly installment is ₹1000 and there are 20 members, the pot in the first month will contain ₹20,000. By the end of the month, this fund will be open for bidding. The bidding is done because there might be multiple people interested in getting the money and the money would go to only 1 person.

Let’s say there are 3 members who need the money by the end of the month. Member 1 bids for Rs 18000, member 2 bids for Rs.17000, and member 3 make the lowest bid of Rs.16000. The lowest bidder will be given the amount by subtracting the fee of the chit fund organizer (called foreman). The surplus Rs.4,000 (called the dividend) is distributed to the other 19 members, after subtracting fees paid to the organizer. The subscriber who won the auction was able to access Rs.16,000 in the first month and the others benefited in their share of the Rs.4,000 surplus.

The process repeats, distributing the auction amount to one member each month. All of the other subscribers, including the ones who took their share in a previous month, continue paying the monthly installments.

Chit fund Rules and Regulations:

Though RBI does not regulate this sector, an act called Chit Funds Act,1982 regulates all of the activities of chit fund companies and prohibits a fund that lacks the prior sanction of the state government.

Chit Fund Act

In August, 2019 Lok Sabha introduced The Chit Funds (Amendment). The Bill seeks to amend the Chit Funds Act, 1982.

The Amendments under this bill are:

  • The term ‘chit amount’ defined as the sum of subscriptions payable by all the subscribers of a chit, changes to ‘gross chit amount‘.
  • The term ‘dividend’ defined as the share of the subscriber in the amount kept apart for running the chit, changes to ‘share of discount‘.
  • Under the act, the maximum commission of a foreman is 5% of the chit amount. Now under the bill, it is of 7%.
  • The term ‘prize amount’ defined as the difference between chit amount and the amount kept apart for running the chit, changes to ‘net chit amount‘.

Risks involved in a chit funds:

  • As it is not an organized sector, the system is exposed to Ponzi schemes such as the Sarada chit fund scandal, Sahara scam, etc.
  • A person has to wait until he/she wins the bid.
  • The returns fluctuate.
  • It requires a very high level of trust. What if tomorrow a few people refuse to continue?

I do not recommend the chit fund because first of all, it is not an investment and the returns you get from chit funds are lesser and not stable.

Every person should make an investment plan to achieve their financial goals. For emergency purposes, the person should get a term plan, health plan and always have an emergency fund.

Thanks for reading. Stay safe.

A chit fund is a type of rotating savings and credit association system practiced in India. But Is it a good investment option?

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