Chit funds 101: Should I invest in Chit fund schemes?

Anish TadimarriOthersLeave a Comment

chit fund scheme

Chit fund schemes are some of the most commonly used investment tools in India. However, there is a negative perception around chit funds because of the chit fund scams of the past. Below, we will discuss in detail what chit fund schemes are, how they work, and who should invest in them.

What is a chit fund scheme?

A Chit Fund scheme is a very popular micro saving and lending tool in India. A chit fund operates under the principle that all members/subscribers agree to contribute a fixed amount of money every month for a fixed period of time. The monthly total is then auctioned off to a subscriber every month. Historically, due to low penetration of banks in India, chit fund schemes became popular serving the lending and saving needs of people.

How do chit funds work?

Let’s look at an example: 

  1. There are 24 subscribers who come together to form a chit fund group.
  2. The term of this chit fund is 24 months. (Usually, chit funds run for the same number of months as there are subscribers.)
  3. The chit fund pool amount is for Rs. 2,40,000. Each member contributes Rs. 10,000 per month.
  4. The group is managed by a foreman (manager) who charges up to 5% as fund management fee.
  5. At the beginning of every month, the foreman will conduct an auction amongst the 24 members. In the auction, whoever bids the lowest amount will be eligible to withdraw the money in that particular month.
  6. In month 1, the foreman will take a bid on who wants to withdraw the amount through the auction. Due to a financial need, some members put in auctions at different prices (Rs.2,10,000, Rs.2,15,000, Rs.2,20,000). The member with the lowest bid of Rs. 2,10,000 wins the auction.
  7. Now, the foreman adds his 5% commission of Rs.12,000 (5% * Rs. 2,40,000) to the winning bid of Rs. 2,10,000. The monthly total is now Rs. 2,22,000.
  8. This is divided up between the subscribers and each pays Rs. 9,250 (Rs. 2,22,000 / 24 members).
  9. This process continues for 24 months. It is the responsibility of the foreman to conduct a fair auction, and to collect/disburse the monthly contribution amounts.

There are many different variations of the chit fund model, but this procedure is more common.

What kind of returns can one expect from chit fund schemes?

Chit funds tend to work both as lending and saving instruments depending on when one seeks to withdraw their money. Members who bid in the first few months usually get only between 60-70% of the chit value. And members who withdraw in the last few months are likely to get upto 90- 95% of chit value.

Hence, chit fund returns can neither be estimated nor guaranteed. If one is looking for savings, it can be said that they are comparable to or better than fixed deposits. A fixed return on a chit fund can never be promised, even by the chit fund foreman. This is because chit funds are distributed through auctions, and auction prices can’t be guessed.

Registered vs Unregistered chit funds?

A registered chit fund is a company that subscribes to the rules put down both by the Chit Fund Act of 1982 and the concerning State government authorities. The 1982 act has laid down very strict regulations and guidelines for chit fund companies to follow. Some of the guidelines concern registration, security collateral, duration, and auction draw.

An unregistered chit fund scheme is one organized by a local player without adhering to the Chit Fund Act of 1982. There is no security of investments with unregistered chit funds as there are no legal protections.

Should you invest in chit fund schemes?

Chit funds have historically been used in India as a way to promote savings. They were effective as they enforced fiscal discipline on the members. Now there are many alternate investment options like Mutual Fund SIPs which might serve the purpose better. One should evaluate these alternative options before investing in chit funds.

Registered chit funds can be an effective savings instrument as they force some fiscal discipline on the members. They provide decent returns but still have an element of risk.

Unregistered chits are very risky with little to no legal protection and should be avoided.

Are chit fund savings taxable?

Chit fund savings are taxable. Let’s say one invests Rs. 10,000 during the course of a chit fund tenure and withdraws an amount of Rs. 12,000. The taxable amount is the difference, Rs. 2,000. This amount will be taxable under the category of ‘Other source’. Conversely, if there is a loss, the same can be reported for businesses and traders.

There is also a GST charge of 12% on the service charge paid to the foreman. However, the GST charge will only be made on 70% of the service charge. For example, if you pay Rs. 1000 as service charge to the foreman, the service charge to be paid is Rs. 84 (12% * 70% * Rs. 1000).

Which chit fund schemes should I invest in?

There are many large chit fund schemes in India today like Margadarshi Chit funds, Kapil Chit funds, Shriram Chits, and the Kerala government run Kerala State Financial Enterprise Chitties. These chit fund companies have operated at a high level of integrity and success for decades. They are a safe choice for someone who wants to invest in a chit fund with minimal risk of being involved in fraud.

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