Chit funds: What they are, how they operate and what are the risks

Of late, Andhra Pradesh's Margadarsi Chit Fund has brought back the discussion around these funds. Here's what chit funds are

Chit funds have been a popular investment option among Indians for a long time. These funds, however, have also stayed in the news for various reasons. Of late, Andhra Pradesh's Margadarsi Chit Fund has brought back the discussion around them.

What is a chit fund?

A chit fund is a type of investment where members agree to come together and deposit a pre-agreed amount of money in a pot. Later, the member who bids the lowest amount for the pot gets the money. It is both a saving as well as a credit product.

It is also known as chitty or kitty.

 

Let us understand it with an example.

Suppose ten people come together and agree to deposit Rs 1,000 every month for ten months in a pot. Here, the duration needs to be equal to the number of members. There is also a foreman who manages the fund and gets a fixed commission in return.

At the end of the first month, 10 members would have deposited Rs 10,000 in the pot. The fund will then conduct a bidding process. The members will have to bid for the pot at a discount. The person with the highest discount will receive the money.

Let us suppose that one member A bids for it at a discount of Rs 1,000. B bids for it at a discount of Rs 800 and C at a discount of Rs 500. A has the highest discount and thus, they will receive Rs 9,000 from the pot value. The remaining Rs 1,000 will be distributed equally among the 10 members.

Foreman's commission will be paid by A from his share.

From next month, all 10 will continue investing Rs 1,000 in the pot. Also, now A will not be able to bid again during the duration of the fund. Like this, all members of the fund get a chance to win the fund. However, A will receive dividends if other members bid with deeper cuts in subsequent months.

What are the benefits of chit funds?

The chit funds are often started by friends or relatives. They offer easy access to money and there is high trust among the members. Moreover, there is not much impact of interest rate hikes. The dividends collected are tax-free and everybody has a chance to get their money back.  

How safe are chit funds?

These funds are regulated by the Chit Fund Act of 1982. It requires the foreman to register the fund with the respective state governments.

The owner of the chit fund has to pay 100 per cent of the chit value as a security with the registrar. The deposited amount can only be withdrawn after the said chit group closes and every subscriber is paid what is due to them.

However, despite everything these funds may lead to scams and frauds.

Risk in chit funds

Big chit funds often appoint agents to add more people. They are given a high commission, in some cases as high as 40 per cent of the money invested in

 

the fund. These agents promise to give three to four times returns to the subscribers. Like this, the fund gets converted into a multi-level marketing scheme.

Gradually, the money is paid to the old members not from the returns on investments but from the money paid by new subscribers. The liabilities soon surpass the actual assets of the fund.

Now, if the fund elopes, the entire money of the investors gets lost. This took place in West Bengal's Sarada Chit Fund scam and the Rose Valley scam.