Imagine you need Rs.30,000 for a medical emergency. But you don’t want the hassle of bank paperwork, and don’t want to pay high interest on a personal loan. What do you do? For millions of Indians: they turn to a Chit Fund.
You might have heard your parents or neighbors talk about “putting money in a chit.” But what is a chit fund? It is a system where a group of people come together to save money and help each other borrow money whenever they require it.
It is one of India’s oldest financial tools. Long before modern banks existed, villagers would pool money to help a neighbor in need. Today, this tradition has evolved into a big industry. In this blog, we will decode chit fund meaning, how chit funds work, and whether Indian chit funds are safe.
What is a Chit Fund?
A Chit Fund is a time-honored financial arrangement that effectively serves as a hybrid of both borrowing and disciplined saving. This is a formal contract between a manager also known as Foreman and a fixed group of individuals known as subscribers. This group agrees to contribute a predetermined, fixed amount of money every month for a fixed period of time, typically equal to the number of members, thus creating a revolving cash “pot” or “chit value” in each cycle. The main principle operating behind this is, every month one individual from the subscribers group gets to take a lump sum money of the pot, but the receiver is determined through a dynamic, competitive reverse auction (or draw of lots). In the auction, members who have instant needs of funds bid by offering a discount on the whole pot amount. The person that accepts the lowest sum (meaning who offers maximum discount) wins the pot amount for that particular month. Here a small commission is deducted by the foreman for managing the whole scheme, and the remaining amount is distributed equally amongst the subscribers of the scheme as dividend, this effectively reduces the net monthly installment for every member. The early winners access funds for urgent requirements (which acts as a loan) while winners that get late benefits of their continuous savings and higher dividends (this acts as an investment), with all subscribers continuing to pay their part till the cycle ends.
To understand how chit funds work, you need to know four simple terms:
- Foreman: The organizer or manager. This can be a person or a company (like Shriram Chits). They collect the money, run the show, and keep records.
- Subscriber: This is the member who puts money in.
- Chit Value (The Pot): The total money collected in a month.
- Dividend: This is the profit earned. When someone takes the pot early, they usually agree to take a little less money. The money they leave behind is shared with everyone else.This extra money reduces the next monthly payment.
How Chit Funds Operate
- Group Formation: A Foreman (the organizer) sets up and manages the fund operations for a fixed period.
- Monthly Contribution: Each participant contributes a set installment (e.g., Rs.5,000). The monthly Pot is formed by the total collection.(e.g., 20 members for Rs.5,000 = Rs.1,00,000).
- The Auction: The Pot is bid by the members who need cash immediately. They win by agreeing to take the money at a discount.
- The Dividend: The Foreman’s fee is paid by the amount saved from the winning bid and remaining amount is divided equally among all members as a Dividend.This dividend effectively reduces their next month’s payment.
- Cycle Continues: This process repeats monthly until every member has had a chance to receive the total pooled amount once.
This system is dual-purpose: it functions as a Savings Tool and a Borrowing Option (if you take the lump sum early).
Benefits of Chit Funds
- Easy to Join: A high credit score or stacks of income proof documents is not required. If the Foreman trusts you, you are in.
- Forced Savings: We have to pay every month so discipline is required here which helps in building a big saving habit.
- Emergency Cash: This acts like an instant loan. In an emergency, you can bid in the auction and get the money quickly without waiting for loan approvals.
- Dual Benefit: Interest (dividends) are earned if you wait till the end. If you bid early, you get a loan. It serves both borrowers and savers.
Risks Involved in Chit Funds
- The Vanishing Act: The biggest risk is joining an “Unregistered” chit fund run by a local guy. You might have very little legal power to get the money if he runs away with it.
- Default Risk: If money is taken by Member A and then the monthly installments are stopped by him, then the loss has to be covered by the Foreman, but if too many people default, the whole system collapses.
- Scams: “Chit Funds” is often used by many frauds to trick people. The famous Saradha Scam was operated as a Ponzi scheme that promised high fixed returns, which real chit funds never do.
Read Also: Top 10 High-Return Mutual Funds in India
Rules and Regulations
To protect everyone from scams, the government created the Chit Funds Act, 1982:
- Registration is Mandatory: Every chit fund company should be registered with the State Government.
- Security Deposit: Foreman must deposit 100% of the pot value in a bank account controlled by the Registrar before starting a chit group. This ensures that even if the company shuts down, the money is safe.
- Commission Cap: The Foreman cannot charge more than a 5% fee (plus GST) for their services.
- Dispute Resolution: If a problem occurs, then visiting a regular court is not required, the Registrar of Chits helps in such a situation for a faster solution.
How to Identify a Safe Chit Fund
- Ask for the PSO Number: Every chit group has a “Previous Sanction Order” (PSO) from the Registrar, It is important to check it once.
- Check for “Registered”: Join only those companies that are registered. Examples include Shriram Chits, Margadarsi, or government-run ones like KSFE (in Kerala) etc.
- No “Double Your Money” Promises: A fixed return is never promised by a Real chit fund.The return depends on the auction. If someone promises a fixed profit then it is likely a scam.
- Read the Agreement: An agreement shall be signed which should consist of details like date, amounts and penalties.
Chit Funds vs. Other Investments
- Chit Fund vs Mutual Fund: Mutual funds are designed for long-term capital, delivering market-linked returns regulated by SEBI. Chit funds function as a system of forced saving with a mechanism for short-term internal loans.
- Chit Fund vs Fixed Deposit: Fixed Deposits offer the maximum safety offered with fixed deposits and guarantees a fixed interest rate.Chit fund earnings are unpredictable as the final dividend depends on the bids placed by the members every month.
- Chit Fund vs Recurring Deposit: They both require monthly contributions consistently. The primary distinction is that RDs are purely savings, while chit funds offer the ability to receive a lump-sum cash advance (borrowing) with the monthly auction.
Read Also: What is an Open-Ended Mutual Fund & How to Invest in it?
Conclusion
One should invest in chit Funds but only if you choose a Registered Chit Fund. It is a beneficial tool for a small business owner, a freelancer, or someone who needs access to funds without begging a bank. It teaches discipline and helps you in emergencies. However, if looking for pure investment growth with zero effort, one must stick to Mutual Funds or Fixed Deposit.
The company’s license should be verified every time. It should be used for short-term goals (like buying a fridge or funding a wedding), not for retirement.
| S.NO. | Check Out These Interesting Posts You Might Enjoy! |
|---|---|
| 1 | What Is An IPO Mutual Fund? Should You Invest? |
| 2 | Mutual Fund Taxation – How Mutual Funds Are Taxed? |
| 3 | What is Solution Oriented Mutual Funds? |
| 4 | What is TREPS & Why Mutual Funds Invest in it? |
| 5 | Debt Mutual Funds: Meaning, Types and Features |
Frequently Asked Questions (FAQs)
Is the money from a chit fund taxable?
The main prize money is not taxable because it is just your own savings coming back.
What happens if the Chit Fund company runs away?
If it is a Registered company, your money is safe. The Registrar holds a security deposit equal to the chit value, which can be used to pay you back.
Can a chit fund be left in the middle?
Yes, but it is costly. A substitute member should take the place, and the company usually charges a penalty (around 5%) for the exit.
Is a Chit Fund better than a Personal Loan?
Often, yes. Personal loans have high processing fees and strict interest rates. In a chit fund, the “interest” you pay is just the discount you bid, which often works out cheaper, and there is no processing fee.
How much return can one expect?
It varies because it depends on how desperate other members are to bid. Though one can expect a return of around 8% to 10% per year.
