Chit funds: Rising popularity, knowing how they work and key red flags

A chit fund  – commonly known as chit, chitty or kuree – is a type of rotating savings and credit association system that has been practised in India and is said to be have been a part of the country’s financial system for over a century.

Chit fund schemes are often organised by financial institutions, or informally among friends, relatives, or even neighbours, and in some variations of chit funds, the savings are for a specific purpose.

A chit fund – commonly known as chit, chitty or kuree – is a type of rotating savings system practiced in mostly India and is said to have been around for over 100 years.

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Chit funds are often microfinance organisations. (Microfinance is a category of financial services targeting individuals and small businesses who lack access to conventional banking and related services.)

Basic example to start off

For example, suppose there is a group of 10 people. Everyone in the group contributes INR 10,000 (Dh500) each month. The total contribution for each month is INR 100,000 (Dh4,900) to the chit fund.

Now, if someone in your group has a financial emergency, the contributed amount of INR 100,000 (Dh4,835) would be given to the person. This way, every month one person will receive the money.

The entire process will go for 10 months. It will be repeated after 10 months.

There are many companies which provide chit fund facility including the Kerala government. And it is also a system used by some communities in the UAE, especially those who want to avoid taking loans.

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Now we have got a basic understanding of the concept of the chit fund, let’s understand how it really works in the modern day environment. Also know, there are many companies which provide chit fund facility including the Kerala government.

Detailed workings of a chit fund

A chit fund comprises a group of members, called subscribers. An organizer, a company or a trusted relative or neighbour, brings the group together and administers the activities of the group.

For their efforts, the organiser is either compensated each month or at withdrawal time. (The fee may be omitted in informal situations.)

The fund starts at an announced date and continues for the number of months equal to the number of subscribers. Each month, the subscribers put in their monthly installments into the pot.

Then, an open auction is conducted to determine the lowest sum a subscriber is willing to take that month.

The person bidding with the ‘deepest cut’ (or discount) gets the pot. But at no point can the bid drop below 40 per cent of the value of the pot.

The fund starts at an announced date and continues for the number of months equal to the number of subscribers.

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To understand the workings, let’s continue with the previous example and resume where we left off.

So, there is a chit fund of 10 members with a monthly contribution of INR 10,000 (Dh483). This makes the per month contribution of INR 100,000 (10,000 X 10).

Now let’s say everyone invested on the first day of the month. By the end of the month, this fund will be open for bidding.

The bidding is done because there might be multiple people interested in getting the money and the money would go to only 1 person.

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Let’s say there are 3 members who need the money by the end of the month. The first member bid for INR 95,000 (Dh4,584), the second member bid for INR 90,000 (Dh4,343) and the third member make the lowest bid of INR 85,000 (Dh4, 101).

The lowest bidder will be given the amount by subtracting the fee of chit fund organiser.

So, the third member would finally get INR 85,000 (Dh4,110). The amount of INR 15,000 (100,000-85,000) (Dh723) is adjusted from the second installment of each person in the group.

It means, in the next installment, every person would pay INR 10,000 minus INR 1,500 (15,000 divided by 10).

Next month, other members will bid, excluding the member who has received the amount, and it will continue for 10 months.

Apart from bidding, another variation of the system that is common, especially when the fund is run among neighbours, is even if two or more people have an urgent need for money, the three pick chits among themselves to see who gets the amount. (The term 'chit' fund comes from such an arrangement.)

Regulating chit fund activities

Organised chit fund schemes are required to register with the Registrar of Firms, Societies and Chits.

A chit fund company is a company that manages, conducts, or supervises such a chit fund, as defined in Section of the [Indian] Chit Funds Act, 1982. According to Section 2(b) of the Chit Funds Act, 1982:

The fund is often run among neighbours, and even if two or more people have an urgent need for money, the three pick chits among themselves to see who gets the amount. The term 'chit' fund comes from such an arrangement.

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Though they are not required to be registered under the Indian central bank regulations, chit fund activities relating to soliciting deposits are governed by the Non-Banking Financial Companies and Miscellaneous Non-Banking Companies Rules (1977) framed by the Government of India under Section 58A of the Companies Act 1956.

Rising use of chit funds abroad

With the advent of ecommerce, chit funds have also started going online, both in India and abroad.

Online chit funds conduct auctions, and subscribers can pay their monthly dues and receive the prize amounts online through online transactions, including electronic fund transfers.

But regarding chit funds that offer the facility to invest and transact online, remember it is difficult to verify details of these companies.

Also, it has been a consistent trend in different parts of the world where a community or even a small group of people get together and start a chit fund.

Now let’s explore in detail the risks that comes along with investing in chit funds.

Weighing the pros and cons

The key advantage for using a chit fund is that when you approach a bank they might reject your loan request due to insufficient proof of document. However, chit funds do not need any document proofs.

But are chit funds better than let’s say a bank loan’s rate of interest. In some cases, yes, but not in all cases.

Chit fund is an option to be considered if you foresee any emergency and would need money which can’t be raised from any other option.

For example, your family member has a critical illness and you don’t have a medical plan. This is the only reason for investing in a chit fund.

Chit fund is an option to be considered if you foresee any emergency and would need money which can’t be raised from any other option.

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Many financial advisers recommend against investing in a chit fund, while admitting it was a good mechanism decades ago when bank facilities were not available.

The reason for this is several chit funds operating today are scamming people.

Moreover, operating chit funds always require a very high level of trust among the members involved. If not, a situation will arise when a few people refuse to continue investing periodically. That results in the chit fund crashing down on all those involved.

Because of such risks, planners instead encourage everyone involved to make investment plans involving assets and such to help achieve their financial goals rather than solely depending on chit funds for income from investment.

For the emergency purpose, the person should get term plan, health plan and always have an emergency fund.

Although, members who do not borrow from the ‘pot’ benefit from dividend accruals; they may earn 7-10 per cent on their investments. Higher the borrowings from the pot by group members, higher the returns at term.

Key risks of chit funds

As touched upon earlier, both organisers and subscribers in chit funds are exposed to credit risk because subscribers might default on their periodic payments.

One analysis of data from two chit fund companies found that 35 per cent of subscribers have defaulted at least once during their tenure at one of the companies and 24 per cent of them have defaulted after winning an auction for the pot.

Chit fund companies can sue defaulters in court but the procedure is time-consuming and is unlikely to produce a timely settlement.

So, it's up to the chit fund organisers to vet the credit worthiness of subscribers (if the subscribers have regular sources of income that improves your credit worthiness).

Chit fund companies can sue defaulters in court but the procedure is time-consuming and is unlikely to produce a timely settlement.

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To reduce the risk of default, some organizers also require subscribers who win auctions to submit sureties (legally authorised documents) for their future liabilities.

Since chit fund payments are not insured by the government, the system is a riskier method of saving than using a bank savings account.

Keep in mind the following points when venturing out into investing in a chit:

• Chit funds are not allowed to collect deposits, so any such scheme, even if the return offered is reasonable, should be avoided.

• Chit funds can operate only in the state where they are registered. So, if it is not registered in your state, do not opt for it.

• Number of chit funds also provide additional incentives to get more members and therefore more contributions. Promising additional returns based on getting new members is a money chain trait and should be avoided.

• Some chit funds offer to exempt prized members from future instalments. This is considered highly illegal.

• Some chit funds offer the facility to invest and transact online, however, it is difficult to verify details of these companies.

Some chit funds offer to exempt prized members from future instalments. This is considered highly illegal.

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• Get a proper receipt and copy of chit agreement on payment of subscription. Also remember to inspect the chit record and registers.