Chit funds have been very popular in India for decades now. A chit fund is a savings cum borrowings scheme. People who are known as members or subscribers come together and invest a fixed amount every month. This is done for a fixed period. Earlier the concept of chit funds was very popular in South India, later it became a norm all over the country. Chit funds are regulated by State and Central government regulations in India.
At the central level, chit funds are governed by the Chit Funds Act 1982. However, over the years chit funds have been involved in frauds. Many fraudulent chit funds have been asked to close down by the government. However, there are still a few large chit companies that remain popular as before. So, how do chit funds work? What are the advantages? Hereâ€™s a look.
How does a chit fund work?
Usually, for chit funds, the number of subscribers in the scheme is the same as the number of months for which the investment is made. Every subscriber will get a chance to take the total amount collected in a month. Every month, one of the subscribers will be eligible for collecting the total amount.
The chit company will put out a bidding system to find out the subscriber who gets the money. Once a subscriberâ€™s turn is done, he/she will not be allowed to participate in the bidding again. If a subscriber is in need of money in the particular month, they will participate in the bidding. The subscriber with the lowest bid will be given the amount.
Who manages the chit fund?
One of the members known as the Foreman will manage the chit fund. The Foreman will be responsible for collecting the subscription amount from all the subscribers. They will record the details of members and will conduct the auctions. The Foreman will be paid a fee to carry out the duties. The fee is usually 5% of the amount collected. The chit company will deduct the Foremanâ€™s fee from the amount paid to the subscriber who wins the bid. If there is any extra amount collected from the monthly subscriptions, it is distributed equally among all the subscribers.
For example, letâ€™s say there is a chit fund with 25 members contributing Rs. 4,000 each per month. They are doing this for 25 months. The total monthly collection made by this chit fund is Rs. 1,00,000. In the first month, there are two members who need money. One needs Rs. 90,000 while the other needs Rs. 95,000. They participate in the bidding. The first member who is the lowest bidder becomes eligible to draw the money for the month. If there are more members bidding for the same amount, a lottery will be drawn to determine which of the members will be eligible for getting the amount.
In our example, the first member can withdraw Rs. 85,000 from the total collected amount (Rs. 90,000 minus the Foremanâ€™s fee of Rs. 5,000 (which is 5% of Rs. 1,00,000)). The remaining Rs. 15,000 (Rs. 1,00,000- Rs. 90,000) is distributed equally among all the members, ie: Rs. 600 each. So, during the first month, each member, in effect, contributes only Rs. 3,400.
On the completion of the 25 months period, each subscriber would have had the chance to withdraw a bulk amount once, in addition to getting an amount every month. Subscribers consider this monthly amount to be interest for their investment. The bidding system is different for different chit funds.
Should you invest in chit funds?
Understand that in India, there are both large chit fund companies like Shriram Chits as well as several small ones. The government in 2018 stated that all chit funds need to be registered. However, note that when fraudulent chit funds closed shop, several investors lost their hard-earned money. It may not be advisable to invest in chit funds. Also, the chit funds donâ€™t promise returns for the investors. It is not possible to calculate even an approximate return from a chit fund because this depends on the bidding system.
This is where mutual funds can help.
Why mutual funds are better than chit funds
Mutual funds are regulated by the Securities Exchange Board of India (SEBI). The investments that you make are handled by a professional wealth expert known as a fund manager. He/she invests the money on your behalf in the best possible stock/debt market securities. Unlike chit funds, mutual fund returns are not dependent on chance. They are dependent on the skills of the fund manager. Debt funds are less risky when compared to equity funds as they invest in fixed income securities. The best of mutual funds has given an average return of over 16% in the past few years.
If youâ€™re keen on making a substantial return that you would later like to withdraw, we definitely recommend investing in Mutual Funds. Click here to explore the best funds.