Should we invest in Chit Funds?

A chit fund is a type of collective instrument in which two people participate, one as the organizer and the other as a member. Several members come together and agree to pool a certain amount of money every month for a set period.

For example, suppose 24 members agree to deposit Rs. 5000 every month for the next 24 months. As a result, in the first month, each of the 24 members deposits Rs. 5000, totaling Rs. 1,20,000 (24*5000).

Every month, the money gathered is auctioned off to anyone who needs it right away.

The organizer arranges an auction in which all members participate and those who desire the money collected (dubbed “the pot”) bid for it. Bidding implies that the member is willing to forfeit a portion of the money to claim the pot. The pot is won by the lowest bidder or the person who is willing to give up the most. The Chit Funds Act of 1982 established a 30-percentage-point limit on how much a member can forfeit.

The money collected in the first month i.e. Rs. 1,20,000 is up for auction. Suppose out of the 24 members there are three members A, B, and C who need the money. Bids for say, Rs 1,10,000. It means he is ready to forego Rs. 10,000. B then bids for Rs. 1,05,000. And C bids for say, Rs. 1,00,000.

The auction is won by C since he bid the lowest, indicating that he is willing to give up the most.

So, after removing the organizer fees, which are capped at 5%, the lowest bidder wins the pot.

Since C has bid for Rs. 100,000. He will get the money after deducting the organizer charges say, 5% of the pot amount which amounts to 120,000*5%= 6000. Therefore, the actual amount received by C is 100,000-6000= 94000.

The amount forsaken by the auction winner is then divided among the other members, which is known as the ‘dividend.’ It is not paid in cash; instead, it is deducted from the member’s monthly instalments. As a result, he pays a lower amount than his real instalment.

The amount foregone by C is 1,20,000-1,00,000= 20,000. This Rs. 20,000 will be divided among all the members as a ‘dividend’ which amounts to Rs. 833 per person. It won’t be paid but will be adjusted from their monthly instalments i.e. from Rs. 5,000 and they would only be required to pay the balance 5,000-833= 4167.

As a result, for the identical pot value of Rs. 1,20,000, the updated instalment amount is Rs. 4,167.

The winning member must still pay the remaining instalments after the auction.

C has won the auction, but he will continue to pay the monthly instalment until the end of the 24-month tenancy.

Every month, the procedure is repeated until all of the members have received their money. A member who has previously taken the money is ineligible to participate in the auction.

C cannot participate in the auction in later months because he claimed the pot in the first month.

If no one bids in the auction in a given month, a member is picked by a fortunate draw and receives the entire sum after deducting the organizer fees.

So that’s how it works with a chit fund.

Unorganized and Organized Chit Funds

Even though chit funds are controlled by law, there are many ‘kitty’ and ‘committees’ that operate on the chit fund concept but are not regulated. This is the unorganized chit fund sector. They are free to make their changes to the model. Unorganized chit funds adapt their depositing and withdrawal methods according to their convenience.

Then there’s the organized sector, which is governed by the Chit Funds Act of 1982 and operates and is controlled by the law. Shriram Chit Funds is one of the few companies that operate in the organized sector.

Many people have lost faith in chit funds since the Saradha Scam in 2013. Even once the restrictions are in place, there is still a significant risk of defaulters and the organizer’s legitimacy. The Act was passed in 1982, but the scam was discovered in 2013, demonstrating that even while the law is in existence, it is not strict or regulated enough, making chit funds an extremely risky business. Despite this, it remains popular in the southern states.

Tax on Income from Chit Funds

The monthly dividend income is neither tax-deductible nor taxable.

The total income is taxable as other sources of income.

The total loss is deductible as a business loss.

For example, if a member receives Rs. 1,30,000 instead of Rs. 1,20,000 at the end of the year, the extra Rs. 10,000 is taxable as income from other sources.

If he receives Rs. 1,10,000 instead of Rs. 1,20,000, he can claim the difference as a business loss of Rs. 10,000.

Should you invest in Chit Funds?

Chit money can be used as both an investment and a borrowing tool. Members in need of funds might bid on the Chit Fund in the early months and win the entire sum.

Members who are not in desperate need of money frequently prefer to take the pot later in the year to earn more money.

Chit Fund is a platform that connects debtors and investors. Chit funds were formerly popular, but in the last decade, they have lost their allure. One of the reasons why people are turning away from Chit Funds is the rise in the number of scams.

Furthermore, the revenue earned by investors is insufficiently lucrative to justify taking such a risk. For borrowers, there are now so many banks and NBFCs eager to lend without collateral that using Chit Funds as a borrowing strategy is no longer viable.

People are becoming less interested in Chit Funds as the number of legitimate channels for borrowing and lending has risen in recent years.