Are chit funds for you?
A chit fund is a traditional savings and borrowing mechanism. As in the case of a kitty party, members pool in a specified amount every month and one of them gets the entire sum. This process is repeated every month till all members get the booty. The difference is that unlike in a kitty party, the winning member is not chosen by a draw of lots, but through an auction.
Bidders accept amounts less than the pooled money in order to get the kitty in a particular month. The lowest bidder gets the pooled sum and the amount he forgoes is distributed among all the members. For instance, if 20 members pool in Rs 1,000 every month, they will have a kitty of Rs 20,000. If the lowest bid in the first month is Rs 16,200, the surplus of Rs 3,800 will be divided equally among the members. This will bring down the first month's net contribution of each member to Rs 810
Bidders accept amounts less than the pooled money in order to get the kitty in a particular month. The lowest bidder gets the pooled sum and the amount he forgoes is distributed among all the members. For instance, if 20 members pool in Rs 1,000 every month, they will have a kitty of Rs 20,000. If the lowest bid in the first month is Rs 16,200, the surplus of Rs 3,800 will be divided equally among the members. This will bring down the first month's net contribution of each member to Rs 810
The chit fund participants see this as a winwin situation. The bidder gets the money he desperately needs, and the other members get to pay a lower sum than the original amount agreed upon. For him, it means a quick loan that he will repay through monthly contributions till the end of the chit. For them, it means better returns on their investment in the chit. The organiser (also known as foreman) of the chit fund also benefits. He gets to keep up to 5% of the gross amount every month as his commission. So, the foreman in our example will pocket Rs 1,000 every month. This money will come out of the kitty amount, so the take-home income will be lower than the amount that the winner of the auction had bid for.
This is the theory. In reality, the going is not as smooth as it seems.
Fraudsters may manipulate the bidding and run away with the money after collecting the kitties in the initial months. Some members may find it difficult to contribute after a few months and drop out. Also, desperate members may drive down the kitty to very low levels. This makes it a very costly loan and increases the chances of default.
So, investors need to be extra careful when they join a chit fund. They should check the antecedents of the promoter of the chit fund and go through the fine print before participating in the scheme. The very first check should be whether the scheme has the necessary approval of the regulatory body. "Chit funds are governed by the Chit Funds Act 1982. They do not fall under the ambit of Sebi's collective investment scheme regulations,"
So, investors need to be extra careful when they join a chit fund. They should check the antecedents of the promoter of the chit fund and go through the fine print before participating in the scheme. The very first check should be whether the scheme has the necessary approval of the regulatory body. "Chit funds are governed by the Chit Funds Act 1982. They do not fall under the ambit of Sebi's collective investment scheme regulations,"
Though chit funds are governed by the central legislation, the administration of the Act is left to the state government. Section 89 of the Act also gives power to the state government to make rules to give effect to the provisions of the Act in consultation with the RBI,
Regulating chit funds
This also brings regulation into focus. The Chit Funds Act 1982 lays down some important ground rules for chit funds. One key guideline is regarding the discount that a member is willing to take on the chit.
The Act says that the prize money, net of the foreman's commission, can't be less than 60% of the total value of the chit. Individual chit funds can keep a higher floor level.
This also brings regulation into focus. The Chit Funds Act 1982 lays down some important ground rules for chit funds. One key guideline is regarding the discount that a member is willing to take on the chit.
The Act says that the prize money, net of the foreman's commission, can't be less than 60% of the total value of the chit. Individual chit funds can keep a higher floor level.
The maximum commission a foreman can charge is also fixed at 5% under the Chit Funds Act 1982.
As mentioned earlier, most chit funds fail because the members who have already received the prize money fail to keep their commitment for the remaining term.
To make sure this doesn't happen, the Chit Funds Act 1982 has laid down that the beneficiary will have to pledge a collateral if his bid for the chit money is successful. One can pledge gold, property, insurance policies, NSCs and bonds, or even provide a personal guarantee from any other member who hasn't yet received the prize money.
To make sure this doesn't happen, the Chit Funds Act 1982 has laid down that the beneficiary will have to pledge a collateral if his bid for the chit money is successful. One can pledge gold, property, insurance policies, NSCs and bonds, or even provide a personal guarantee from any other member who hasn't yet received the prize money.
Should you save or borrow?
We have already explained that a chit fund is both a saving and borrowing option. If you don't bid for the money till the end, it is like a recurring deposit. You get your money back at the end of the chit's term. Though the sum received will be fixed, your returns will depend on the distributable surplus over the months. There is no assurance of return, nor a fixed formula for how much you can gain. In our example (see table on page 1), the person who waits till the 20th month pays Rs 18,100 over the entire tenure and gets Rs 19,000 in the end. The return works out to 6.3%, which is not very attractive when most banks are offering yields of up to 9% on recurring deposits.
We have already explained that a chit fund is both a saving and borrowing option. If you don't bid for the money till the end, it is like a recurring deposit. You get your money back at the end of the chit's term. Though the sum received will be fixed, your returns will depend on the distributable surplus over the months. There is no assurance of return, nor a fixed formula for how much you can gain. In our example (see table on page 1), the person who waits till the 20th month pays Rs 18,100 over the entire tenure and gets Rs 19,000 in the end. The return works out to 6.3%, which is not very attractive when most banks are offering yields of up to 9% on recurring deposits.
Despite these shortcomings, investors flock to chit funds in large numbers. This is because the option offers tremendous flexibility to the member. He can treat it as a recurring deposit till he needs the money, just like an overdraft facility with a bank. Most people use chits to save for short-term goals, such as buying a vehicle or setting up a business. They are especially useful for goals that can crop up anytime during the tenure of the chit, such as a child's wedding or the purchase of a house.
Tax benefits and treatment
There are also some tax benefits in chit funds. A member who wins an auction by accepting a lower payment can set off the loss from the chit against business income. This reduces the cost of capital for the borrower. However, this benefit is available only to businessmen and traders.
Salaried persons cannot set off the loss against their income. On the other hand, any profit made by the last person in the chit is taxable. The amount is to be shown as income from other sources in the tax return and taxed at the marginal rate applicable to the individual. This further reduces the attractiveness of chit funds as a saving instrument.
There are also some tax benefits in chit funds. A member who wins an auction by accepting a lower payment can set off the loss from the chit against business income. This reduces the cost of capital for the borrower. However, this benefit is available only to businessmen and traders.
Salaried persons cannot set off the loss against their income. On the other hand, any profit made by the last person in the chit is taxable. The amount is to be shown as income from other sources in the tax return and taxed at the marginal rate applicable to the individual. This further reduces the attractiveness of chit funds as a saving instrument.
Should you invest?
Considering the high cost of capital and the low returns offered by chit funds, this option is not advisable for the average investor. Any bank will extend a personal loan at 22-24% and most recurring deposits offer yields of 8-9%. Only if you have a rather bad credit history and a bank loan is out of the question should you consider joining a chit fund. However, keep in mind that the chit fund company will also insist on a collateral when your bid for the kitty is accepted.
Considering the high cost of capital and the low returns offered by chit funds, this option is not advisable for the average investor. Any bank will extend a personal loan at 22-24% and most recurring deposits offer yields of 8-9%. Only if you have a rather bad credit history and a bank loan is out of the question should you consider joining a chit fund. However, keep in mind that the chit fund company will also insist on a collateral when your bid for the kitty is accepted.
For those looking at chits as a saving option, a bank fixed deposit or a recurring deposit will offer better returns. Only if you don't have access to regular banking should you consider a chit fund. Automate your investment if you lack the discipline to save.
Unregistered chit funds are popular among traders and small businessmen because they are able to put the unaccounted for money to use. In most such cases, the money is paid in cash. Small shopkeepers find it easy to part with Rs 50-100 on a daily basis so that they can get a lump sum 18-24 months later.
Unregistered chit funds are popular among traders and small businessmen because they are able to put the unaccounted for money to use. In most such cases, the money is paid in cash. Small shopkeepers find it easy to part with Rs 50-100 on a daily basis so that they can get a lump sum 18-24 months later.
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