We Design Your Financial Destiny

(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

Is Chit Fund always a Cheat Fund?

First and foremost, one must understand that Chit Fund is NOT an investment.

It is merely a COLLECTION scheme where
... individuals get together to form a group
... each member contributes a specified amount every month to a kitty
... total collection for the month is given to one person among the group
... each member receives the monthly collection once, till the cycle is complete

For example
... 15 friends form a chit fund
... each contributes Rs.1000 per month
... every month one of them receives the Rs.15,000 collected
... this continues for 15 months till each friend gets the monthly collection once

In simple terms,
- for the person who receives 'net' Rs.14,000 in the first month itself (Rs.15,000 less his own contribution of Rs.1000), chit fund is like a loan where he pays the EMI of Rs.1000 over the next 14 months
- for the last person in the group, chit fund is like a deposit where in the 15th month, he gets back the Rs.14,000 he had deposited over the previous 14 months
- for the rest of the members, it is a loan-cum-deposit combo product.

Now let us look at some of the key questions...

Where do the returns come from?
If each member contributes Rs.15,000 (@Rs.1000 for 15 months) and gets the total monthly collection of Rs.15,000 once, the returns are zero.

This is where the concept of "auction" comes into picture. There is a bidding that happens every month for the monthly kitty.

Those who have a financial need that month, will bid for the monthly collection, by accepting the amount at a discount. Indirectly, it is like paying an up-front interest cost to borrow this sum of Rs.15,000. Naturally, the one who is ready to accept the lowest sum, gets the money.

Suppose A is ready to give a discount of Rs.2000 and take only Rs.13,000. However, B offers to take only Rs.12,000 with Rs.3000 as discount. Thus, that month's kitty goes to B.

The difference of Rs.3000 which remains is distributed to each member (Rs.3000/15 = Rs.200) as his profit. This is how each member earns his returns every month.

What are Chit Funds and should you join such a scheme?

What are the costs and taxes involved?
There is generally an "organizer or promoter" of a chit fund, who charges a fixed fee 'every month' to conduct the scheme.

This is typically around 5% (e.g. Rs.15,000 * 5% = Rs.750). This is paid by the member receiving the monthly collection. Effectively speaking, you are paying so-called fund management charges of Rs.50 (Rs.750/15 members) every month.

As you will appreciate, 5% is pretty steep when compared to say depositing your money in a bank (at zero cost) or taking a bank loan (at maximum around 1-2% loan processing fees).

Coming to taxation, gains from chit funds enjoy NO tax breaks. You will have to pay tax as per your income tax slab rate on the returns that you earn every month. And losses (or interest), if any due to aggressive bidding, are a write-off (except in case of businessmen / traders, who can adjust it against the profits from their business).

Thus, you can see that
- there is no assurance of how much returns you will earn in a chit fund
- there is no guarantee that all the members will continue contributing till each person gets the monthly collection
- liquidity could prove expensive depending on the bids when you are in of need money
- there is no flexibility as once you opt for it you can't stop in-between

In short, chit fund is a high-risk, high-cost, rigid scheme with no assurance of returns.

Should you join a chit fund?
The answer is pretty simple. 

No... if you have easy access to a bank where you can avail both the facilities i.e. deposits and loans, on highly competitive terms.

But for people from the lower strata of the society or from the informal sector, even opening a bank account can be a nightmare. Being financially excluded from the safe and secure organised sector, they have no recourse but to depend on chit fund types of schemes.

For such people gold and chit funds are, perforce, their primary deposit / borrowing options.

Why have chit funds earned such a bad name?
As is quite clear, chit funds work on one simple factor... trust. As long it is a small group where members are known to each other, it is relatively easy to ensure that there are no irregularities.

Problems crop up when the promoters or organizers form a very large group running into thousands of subscribers. Then, these members have practically no control over each other, or the promoters or the day-to-day running of the scheme.

For example, 
a) As the group size increases, the members who cannot continue with their contributions goes up.
b) Really desperate members bid very low and then are unable to continue with their deposits.
c) Those who receive monthly kitty early deliberately default on their future monthly deposits.
d) Monthly bidding is manipulated.
e) People are lured through promises of high returns even though the yields are impossible to predict
f) Illegal incentives are given to enroll new members.
g) Chit fund is run as a fraudulent ponzi or pyramid scheme where the promoters finally run away with the money.

Even though there are laws [Chit Funds Act, 1982 and several State Laws] in place for registration and regulation of such schemes, the enforcement is very poor. This makes it very easy for the crooked people to commit fraud. Many unscrupulous elements have taken advantage of this and converted the chit fund into a "cheat" fund.

Therefore, extreme caution and extra due diligence is necessary in case you have ABSOLUTELY no other option but to join any such chit fund.

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

101 Classic Tips Money Gyaan

You Learn A Lot By READING... And Even More By SHARING.

Share Button

Ignorance is like a SIGNED BLANK CHEQUE... anyone can MISUSE it.

Subscribe via Email
Powered by Blogger.

... Three VALUABLE Tips ...

1. Why Mutual Funds Won't Survive On The Planet Mars
No Mutual Funds on Mars
Mutual Funds would be a totally ALIEN concept on planet Mars.


2. 10 Key Features of 'Standard Individual Health Insurance'
Standard Individual Health Insurance
Salient aspects of the Arogya Sanjeevani Policy.


3. Refinance Home Loan In Early Years (For Maximum Gains)
Loan Refinancing
Think before you make your move to refinance your loan.