Chit funds involve a financial setup where a group of individuals contributes a set amount of money at regular intervals. The arrangement entails that one member of the group receives the entire pooled sum during each interval, based on prior agreement or understanding.
The Rajya Sabha took a significant step forward in bolstering the financial security of India's economically weaker sections by passing the Chit Funds (Amendment) Bill, 2019. This legislative action, undertaken in the year 2019, was aimed at streamlining the operations of collective investment schemes, commonly known as chit funds, with a focused objective to safeguard the interests of investors.
While chit funds have played a significant role in the financial inclusion of the unbanked and underbanked segments of the Indian population, the emergence of the Bajaj Finserv Mutual funds platform provides an alternate opportunity for investors to invest in 1000+ mutual funds and potentially achieve higher returns.
In this article, we will explain what a chit fund is, how they work, what their benefits and risks are, and how to invest in them.
What are chit funds?
Chit funds are a traditional financial tool popular in India, combining savings and borrowing within a single scheme. Managed by registered chit fund companies or informal groups, these funds work by forming a group of individuals who contribute a fixed sum regularly to a common pool. This pool is then auctioned or distributed to one member of the group during each cycle, usually determined through bidding or a lottery system.
Chit funds serve dual purposes: they act as a savings mechanism and provide access to funds in times of need. The organiser, often the chit fund company, charges a fee or commission for managing the operations. Chit funds are regulated by the Chit Funds Act, 1982, to ensure transparency and safeguard participants’ interests, though unregulated schemes still exist.
They are particularly popular in rural and semi-urban areas due to their simplicity, flexibility, and accessibility. Chit funds are versatile, catering to various financial needs like household expenses, business investments, or emergencies. However, they come with risks, especially if run informally or without adequate oversight. Participants should choose reputable, registered chit funds to minimise risks and maximise benefits.
How do chit funds work?
The basic mechanism of a chit fund is as follows:
- Fixed number of subscribers, monthly instalment, and duration.
- Managed by an organiser/foreman (also a subscriber): responsible for collection, auctions, distribution, and record-keeping.
- Organiser's fee: Percentage of chit value.
- Chit value: total monthly collection.
- Prize money: Auction/lucky draw winner's amount, less than chit value due to organiser's commission and subscriber discount.
- Discount: Amount the winner agrees to forego, shared as dividends among non-winning subscribers.
- Dividend: Profit is shared among subscribers from the discount, reducing next month's instalment.
- Net liability: Monthly payment by subscribers after dividend deduction decreases over time as dividends increase.
Chit fund example
The following table illustrates the working of a chit fund scheme with 50 subscribers, each paying Rs. 1,000 per month, for 50 months, with a 5% organiser commission.
Month |
Chit Value (In Rs.) |
Prize Money (In Rs.) |
Discount (In Rs.) |
Organizer Commission (In Rs.) |
Dividend (In Rs.) |
Net Liability (In Rs.) |
1 |
50,000 |
40,000 |
10,000 |
2,500 |
153 |
847 |
2 |
50,000 |
41,000 |
9,000 |
2,500 |
132 |
868 |
3 |
50,000 |
42,000 |
8,000 |
2,500 |
112 |
888 |
49 |
50,000 |
48,000 |
2,000 |
2,500 |
10 |
990 |
50 |
50,000 |
49,000 |
1,000 |
2,500 |
0 |
1,000 |
The table shows that the first prize winner gets Rs. 40,000, after deducting Rs. 10,000 as the discount and Rs. 2,500 as the organiser commission. The remaining Rs. 7,500 is divided among the other 49 subscribers, who each get Rs. 153 as the dividend. The dividend is added to the next month's instalment, reducing the net liability to Rs. 847. The process is repeated every month, with the prize money increasing and the discount decreasing. The last prize winner gets Rs. 49,000, after deducting Rs. 1,000 as the discount and Rs. 2,500 as the organiser commission. The other subscribers do not get any dividend in the last month, and have to pay the full instalment of Rs. 1,000.
Also read: Different Types of Investments
Features of chit funds
Chit funds are traditional savings schemes where participants contribute a fixed amount to a common pool over a specified period. Each member has the chance to bid for the pooled money through an auction process or lottery, depending on the structure. While chit funds offer liquidity and access to funds, they differ from mutual funds, which focus on pooling money for investments in financial assets. Chit funds are often informal and used for meeting short-term needs, while mutual funds are regulated investment products designed to grow wealth over the long term. The risk-return profile also varies significantly between the two.
- Pooling of resources: Participants in chit funds regularly contribute a fixed sum, creating a pooled fund. This pool is distributed periodically to one member, ensuring liquidity. Unlike mutual funds, where the pool is invested in market instruments, chit funds are used mainly for personal or business financing needs.
- Bidding process: A key feature of chit funds is the auction system. Participants bid to receive the pooled amount, often offering a discount to the total sum. This bidding process determines who gets the funds, which is different from mutual funds that rely on market performance for returns.
- Flexible usage of funds: Chit fund winners can use the money for various purposes, such as paying off debts, personal expenses, or business ventures. This flexibility contrasts with mutual funds, where the funds are invested in specific securities for wealth generation over time.
- Unregulated or informal: Many chit funds operate informally, especially in rural areas, and lack the regulatory oversight seen in mutual funds. This can make chit funds more accessible but also riskier due to potential defaults or frauds, which are less common in regulated mutual fund schemes.
- Risk factors: Chit funds carry unique risks, including the potential for defaults by other members. If participants fail to contribute, the fund's overall stability is threatened. In mutual funds, risk comes from market fluctuations, but the funds are managed by professional asset managers.
- Liquidity and flexibility: Chit funds are designed to provide quick access to money, offering liquidity to participants when they need it most. Mutual funds, on the other hand, have varying levels of liquidity depending on the type of fund, with some imposing exit loads or lock-in periods.
- Short-term focus: Most chit funds are short-term, running over a few months to a few years, focusing on immediate financial needs. Mutual funds, however, are typically structured for medium to long-term wealth accumulation, with investment horizons of several years.
Benefits of chit funds
Chit funds have several advantages over other forms of saving and borrowing, such as:
- They are easy to join and operate, as they do not require any documentation, verification, or collateral.
- They offer a high rate of return, as the subscribers share the profit from the auction among themselves.
- They provide liquidity and flexibility, as the subscribers can access the money anytime they need it, without any penalty or interest.
- They encourage saving and financial discipline, as the subscribers have to pay the instalments regularly and punctually.
- They foster social bonding and trust, as the subscribers belong to the same community or network.
What are the different types of chit funds?
Chit funds offer flexibility and mutual financial support among members. They come in various forms, each catering to different needs and preferences. For more clarity, let’s study their various types:
Special purpose chit funds
These chit funds are created for a specific goal or occasion. For example, a group of people might pool their money to save for an event like Diwali. The fund will end shortly before the event. This type of chit fund allows the members to use the saved money for that specific purpose.
Organised chit funds
In these chit funds, members meet regularly, either monthly or weekly. During these meetings, the names of the members are written on small pieces of paper and placed in a box. Next, the group leader randomly draws one name from the box, and the person whose name is drawn gets the entire pooled fund for that meeting. Once someone wins, they cannot win again in future meetings, but they must keep contributing their share of the money until the end of the fund.
Online chit funds
With the advent of digital technology, chit funds have also moved online. In such online chit funds, the process of determining who will receive the pooled money is conducted over the Internet. Members participate in a digital auction rather than meeting in person. They also make their contributions and payments electronically through online banking or other digital payment methods. This modern approach offers convenience and allows members to participate from anywhere.
Registered chit funds
These chit funds are officially registered with the Registrar of Societies, Chits, and Firms. They are regulated by the Reserve Bank of India under the Chit Fund Act of 1982, which applies throughout India. This regulation ensures that the funds are managed legally and transparently.
Unregistered chit funds
Unregistered chit funds are informal arrangements usually started among colleagues, friends, or family members. These are not registered with any official body and are mostly used as a way for the group to save money together. Since they are unregistered, they are not regulated by any official laws or guidelines.
Also read: What Is Hindu Undivided Family
Is chit fund legal?
Chit funds are legal in India when operated under the regulatory framework of the Chit Funds Act, 1982. This Act provides guidelines to ensure transparency, protect subscribers, and govern the operations of chit fund companies. Only registered chit fund businesses, adhering to the rules set by state governments and the Registrar of Chits, are considered lawful.
Legal chit funds must maintain detailed records, organise regular auctions, and provide a clear distribution of funds. The companies are required to deposit a security amount with the Registrar, ensuring subscribers' interests are safeguarded against financial irregularities. Additionally, participants have legal recourse in case of disputes or fraud involving registered chit funds.
However, many unregistered or informal chit funds operate outside this legal framework. These pose significant risks as they lack accountability and regulatory oversight. Instances of fraud and mismanagement in such schemes have led to financial losses for participants.
To ensure legality and safety, individuals should verify the chit fund's registration status and track record before joining. Engaging in legally compliant chit funds can provide both savings and borrowing opportunities, but caution is crucial when dealing with unregulated schemes. Always prioritise transparency and credibility while choosing a chit fund.
