Check options well before investing in chit funds

Written by Adhil Shetty | Updated: Jan 26 2013, 07:08am hrs
A chit fund is a savings-cum-borrowings scheme, wherein a few people (known as members or subscribers) come together and invest a fixed amount every month for a fixed period. While the concept of chit funds has been very popular in South India for several decades, other states too have chit fund concepts now. Various state and Central regulations regulate chit funds in India. At the Central level, the Chit Funds Act, 1982, governs chit funds. Some states also have state-level laws. Chit funds have been associated with fraudulence for past couple of decades. Many fraudulent chit funds have closed down. Nevertheless, a few large chit companies have retained their popularity among people.

Lets understand more on chit funds

How does a chit fund work

In a chit fund, the number of months for which the investment is made is the same as the number of subscribers in the scheme. Every subscriber gets a turn to take the total amount collected in a month; this means, in every month, one subscriber will get the collected amount. The subscriber to get the money will be decided based on a bidding system. Once a subscriber gets his turn, he is not allowed to participate in the bidding again. Generally, those who are in need of money in a particular month participate in the bidding, and the subscriber with the lowest bid is allowed to take the amount. The chit fund scheme is managed by one of the members, who is known as the Foreman. He is responsible for collecting the subscription amount from the subscribers, recording details of members and conducting the auctions. For these duties, he is paid a fee, which is generally 5% of the amount collected. The Foremans fee is reduced from the amount paid to the subscriber who wins the bid. Any extra amount from the monthly collections is distributed equally among all the subscribers.

Illustration: Lets assume there is a chit fund with 10 members contributing R3,000 each per month for 10 months. The total monthly collection in this chit fund is R30,000. Suppose in the first month, there are two members who need funds, who participate in the bidding. One member bids for R27,000 while the other member bids for R26,000. The second member becomes eligible to draw the money for the month as his bid is lower than the first members bid. If there is more than one member bidding for the same amount, which happens to be the lowest amount, a lottery is drawn to determine which of the members will be eligible for withdrawing the amount. In this illustration, the second member can withdraw R24,500 from the total collected amount (R26,000 Foremans fee of R1,500 (which is 5% of R30,000)). The remaining R4,000 (R30,000-26,000) is distributed equally among all the members that is R400 each. So in effect, during the first month, each member contributes only R2,600.

In the second month, another member is given a chance to withdraw the bulk amount. Suppose this member bids for R28,000, the remaining R2,000 is divided among the members that is R200 per member. This process is repeated every month for a total of 10 months. On the completion of 10-month period, each subscriber would have withdrawn a bulk amount once, in addition to getting the monthly nominal amount. This monthly amount works like a dividend for the money invested. Rules for determining which member takes the bulk amount every month and also the withdrawal amount vary from one chit fund to another in different states.

Should you invest in chit funds

This question can be answered from two angles from safety viewpoint and investment viewpoint. In India, there are both large chit fund companies like Shriram Chits and Margadasi Chit Funds as well as several small unregistered ones. Registered funds are regulated and governed by law, but unregistered chit funds are not bound by any regulations. When fraudulent chit funds closed shop, several investors lost their hard-earned money. It is, therefore, not advisable to invest in such unregistered chit funds. Further, it is not advisable to invest in chit funds where the other members are unknown to you. Thus, the key to investing in chit funds is in choosing the right one.

However, from an investment point of view, a chit fund does not promise returns for an investor. It is not possible to calculate exact returns from a chit fund as this depends on the level of emergency of members for funds, and this is a highly variable factor. A chit fund is a good savings instrument for small investors and brings about a discipline in saving regularly. It is also useful in getting funds when in an emergency. As chit funds are essentially not investment products, you must consider investing in them only if you foresee a need for funds in the near future, which you may not be able to get from your bank, and thus start saving towards this need in a chit fund.