Here are few points to ascertain whether Chit Funds are worth Investing or not:
Chit funds are very popular among small business people, homemakers, lower and middle-income class, alike. They are savings cum borrowing schemes, which brings both the savers and borrowers on the same platform, which is owned by the Chit Fund owner. The concept of chit funds is very native to our country.
Though Chit funds, also known as a kitty, chitty, etc., are recognised by the government under Chit Fund Act, 1982, there are very few chit funds which are registered. Lot many unregistered chit funds operate throughout the country, run by a network of friends, relatives, etc.
Being a savings cum borrowing scheme, it attracts a lot of people who want immediate liquidity or want to raise an immediate capital/loan. Also, individuals with low credit score, tend to utilise these schemes for borrowing.
But is it a good savings/investment scheme?
Chit funds come with a high degree of risk, to the possibility of the chit fund owner escaping with the collected money, to the subscribers refusing to pay after taking their chit amount, the chances of fraud are very high.
How does Chit Funds work?
Let us look into a case study to understand how the chit funds work.
The ABC Chit Fund Company runs the chit fund business from past 10 years. Assume it starts a new chit, from April 2017. The new chit is open for 20 people, with a maximum contribution of Rs.1000 per month for 20 months. The subscribers of this chit, pay the monthly subscription amount to the chit fund company, also known as agent/foreman. The agent is responsible for bringing together, people with similar saving capacity, or similar borrowing requirements.
Amount collected per month = 20*1000 = Rs.20, 000 – this is known as the Chit Amount.
Once the first month’s payment is received, bids are invited from all subscribers. Any subscriber, who is in need of money, can bid for the chit amount, at a lower amount than it.
Assume. Mr Nakul wants money immediately, and bids at Rs.15, 000 i.e. he is willing to forego Rs.5000 so that he can get money immediately. This Rs.5000 is considered as “profit” of the chit.
The foreman/agent/company which organises the chit also has to be paid a commission, which could be up to 5% of the bid amount.
Foreman/Agent commission = 5%*20000 = Rs.1000
This commission is deducted from the amount given to the bid winner. So, Mr Nakul gets Rs.14, 000 only. After this, Mr Nakul is not allowed to bid again but has to continue to pay monthly subscriptions.
In the 2nd month, Rs.5000 deducted from Mr Nakul will be distributed among all the 20 chit members.
Profit/chit subscriber = 5000/20 = Rs.250
So, in the 2nd month, every subscriber of the chit has to pay only Rs.750.
This way, bids are invited every month for 20 consecutive months, and the chit amount is given to the lowest bidder, till every subscriber gets the chit amount once.
The profit derived is distributed equally, and is called as the dividend. The profit the subscriber makes from the chit is the distributed dividend, which he receives immediately. Depending on the bidding amount, the monthly amount that is to be paid by the subscriber is always less than the upper limit of Rs.1000.
Though the logic seems simple, there are a lot of risks associated with it, which might make your savings vanish into thin air.
Are chit funds useful?
Well, there are many small businessmen, housewives, etc., who depend on chit funds for many of their needs. The reasonably quick access to the chit amount is very convenient for them, to raise capital when needed. It also saves them the hassles of paperwork, as in the case of loans.
Also, it acts a small savings scheme for many people, as the chit funds run many chits, with various denominations of the chit amount. The chit amounts range from as low as Rs.5,000 to as high as Rs.1 crore. The monthly contribution will also be as low as Rs.200, to as high as Rs.5 lakhs per month.
Since chit funds don’t conduct background checks or credit score checks, it is easy for people with low credit scores also, to avail finance.
What is wrong with the rationale of Chit Funds?
Chit funds work on a simple logic of collecting funds from a group of people and distributing it based on the urgency of their requirement. It also works as a savings scheme for those who don’t need the money immediately.
1. Both Savings cum Borrowing Scheme
It can be either a savings or a borrowing scheme. In your overall financial roadmap, it ‘s hard to map it to a goal, as you may be either saving or borrowing, i.e. you may be making a profit or a loss.
2. No guarantee of profit
There are no returns promised on the amount, you pay as a subscription. You might make a profit or loss, depending on when & how much you bid for.
3. May receive chit amount, when not needed
It is a common problem faced by the chit fund investors. When all/most of the subscribers of chit are interested only in saving money, they would not want to bid in between the term. Under such circumstances, the chit fund chooses the bidder by drawing from a lot, and he has to forego an amount fixed by the foreman. This situation results in subscriber receiving the chit amount when he doesn’t need. This situation of getting an unwanted surplus, when least needed, may lead to quick spending, and the planned goal may even go un-achieved.
4. No check on creditworthiness
The foreman or the chit fund company may form a group consisting of unknown individuals, without a check on their creditworthiness. There are high chances of a subscriber stopping monthly payments after a few months, or a winning bidder absconding after receiving the chit amount. It will reduce the profit you make from the chit; you may also end up losing your capital.
If you observe the facts mentioned above, there are lot many loopholes in the way chit funds operate, which may out your money at risk.
Risks of “saving/investing” in a Chit Fund
As mentioned earlier, lot many people subscribe to chit funds to save money. The ease of monthly payments and easy liquidity is a major draw for them. It is a preferred option in smaller towns and villages since they feel it is better than raising a loan, on interest.
Let us understand some of the risks associated with chit funds:
1. Background of the foreman/agent not known
Private unregistered chit fund forms a significant chunk of the chit fund industry in our country. However, such funds are run based on personal trust or through references from friends or relatives. The background of the foreman/agent is not known. The foreman can just run away after collecting the amount from the subscribers.
2. Risk of bankruptcy in private registered chit funds
Most private chit fund operators, who are registered, own multiple businesses in various sectors. They might utilise the inflow from chit fund operations, for other business interests. If their businesses fail, the chit subscribers also stand to lose their money.
3. No investor protection
Unlike banks, which are backed by the RBI, chit funds have no backing by the government. Even if a registered chit fund company files for bankruptcy, neither the government nor the RBI will come to the rescue of the investors.
4. No guaranteed returns
Since every chit is unique because of different bidding amounts, the returns generated is unknown. It might even lead to a loss, without the investor being aware of it.
5. Have to stay invested for long term, if you expect a profit
If you are saving monthly in a chit fund, you should not bid till the fag end of the term, if you hope to make a profit. As the term progresses, you may get the chit amount for a low bid. Even then, profit is not guaranteed, as it depends on the bidding amounts throughout the term. If you want the chit amount in between the term, it becomes more like a loan, and hence, results in a loss.
Comparison between a monthly investment in RD, SIP in a Debt Mutual Fund and Chit Fund
Let us compare some of the popular monthly saving options, such as RD in a bank and SIP in a Debt MF, with a chit fund monthly subscription.
By now, you must have understood how Chit funds work. With no guaranteed returns or investor protection, investing in chit funds is a dangerous proposition. But, if you are a credit hungry borrower without a credit history, then it might work for you.
This article should not be construed as investment advice, please consult your Investment Adviser before making any investment decision.
If you are looking for a SEBI registered Investment Adviser visit mymoneysage.in