How Chit Funds Work?
Chit Funds (also known as Chiti) are a very old and popular type of savings instrument used in many parts of India. It is most popular in Kerala with almost 10% of families investing in chit funds. However, it is also commonly used in Andhra Pradesh, Tamil Nadu and North India.
A lot of people have heard about chit funds, but do not clearly understand how it actually works and whether it is safe to invest in them. In this post we will answer these questions.
Chit funds are generally formed by a small group of people, generally family members, neighbours, or friends. The idea is that the people forming the chit fund are generally known to each other and have the faith that the members of the fund will not default (However, this does not always happen).
In a chit fund, this small group of people, say 10 members, will start a chit fund scheme, and decide to invest Rs. 1,000 each every month for 10 months (equal to the number of members). Every month, on a fixed date, they will get together and pool this money together. Among these 10 members, one member will be the organiser who will do all the work for arranging this. He will get an organizing fees of 5% of the total pool money. Once the money is pooled, this money will be given to one member based on the auction (bidding) system. Each month, some members, who are in need of the money, will decide to bid for the pool.
The total amount in the pool is Rs, 10,000, and the bidding will start. Someone may bid Rs. 9,000, that is, he is willing to settle for a discount of Rs. 1,000. Someone else who is in more need of money will bid for a lower amount, say Rs. 8,000. The lowest bid will get the money. If the lowest bid is Rs. 8,000, then, that person will get Rs. 8,000 minus Rs. 500 (organiser fees), i.e., Rs. 7,500. If there were two people who had bid the lowest amount, then using the lottery system, the amount will be given to one of the members.
The balance money of Rs. 2,000 will be equally divided and returned to all the members.
Next month, again the same process will repeat, and this will continue for 10 months. Once a person has received the prize money, he is not eligible to bid in the subsequent months. However, is is obligated to participate and pay is share of money. If he doesn’t, the chit scheme will default.
This practice may very from region to region. For example, in North India, they don’t generally have an auction system. Instead, they just follow a lottery system. Each member’s name is written on a chit and put in a box. One chit is picked, and whoever’s name it is gets the prize money.
Different chit fund schemes will have a different number of members and different amount of investment per month.
Is it an Investment?
If you do the maths, you will notice that at the end of the 10 months, all the members of the scheme would have got their money invested, excluding the organizer’s fees. So, they don’t get any interest or income over their money invested. In that sense, it is not really an investment vehicle. It is more suited for people who are need of bulk money. So, if you are looking at investing your money, then chit funds are not the right thing.
If you want to participate in a chit fund, it is advisable to participate in one with your close friend or family circle. There are many big chit funds available, however, they are highly prone to fraud. Any chit funds where you don’t know atleast a few members personally should be avoided.