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What is a Chit Fund and How Does it work?

Haven’t you seen the Pyramids of Egypt? Have you ever wondered how they were built to such a height? If you look carefully you will see that they were built out of limestone blocks which were at one point of time well just a block of stone. By careful joining and building up of these individual blocks you get the pyramids you see today. Do you notice any similarities with these pyramids and Chit Fund Schemes in India? Both of them have a same starting point. You must have heard the phrase " Think Big Start Small ". In India this phrase is taken to the next level using the chit funds. These funds have helped scores of people in their time of need .In India especially in the southern parts this is a rampant scheme and is used to finance immediate needs and even children’s marriages. Lately these funds are in the news for the wrong reasons. Now a few rotten apples threaten to topple the whole apple cart. At this point of time one remembers the famous saying" Do Not Throw The Baby With The Bathwater ".

What Is A Chit Fund?

Chit funds are defined under Section 45I(c) of the RBI Act categorizing them as a miscellaneous non banking company. A Chit fund company is governed under section 2 (b) of the chit funds act 1982 and is involved in managing conducting or supervising as a foreman or an agent or in any capacity for a chit fund. A chit is basically a transaction whether it is called a chitty, kuri, chit, chit fund or any other name under which a person enters into an agreement with a specified number of persons and each one of them agrees to subscribe for a certain sum of money by way of periodic installments over a definite time period and that each subscriber shall in his turn as determined by a lot or an auction or a tender as may be specified in the chit agreement be entitled to a prize amount. Chit fund companies are not allowed to accept deposits from the public, trade in stocks and indulge in cash management schemes. These schemes cannot carry on any investment work without the permission of the State Government.

How Does The Chit Fund Work?

You know that a chit fund is an arrangement among a group of people to contribute money at a periodic interval of time to create a pool of funds called a chitty. Any member who is part of this scheme can draw a lump sum amount based on a lottery system, an auction or even he can fix a payout date if he knows of a definite expenditure at a future date.

Let us consider that you and nine other members in your neighborhood join together and have decided to make a monthly contribution of INR 5000 for a year. This translates to a net pool of INR 50000 for your pool of 10 members. On a certain day of each month a bid is made by the group of members .Among the 10 members suppose 3 members of your group are in need of funds immediately, they would place their bids. One of the members in your group bids for an amount of INR 42000, another INR 45000 and the third member bids for INR 44000.You need to remember that the maximum bid amount cannot exceed the totaled pooled amount in this case INR 50000.Accordingly to the chit fund principle the lowest bidder gets the amount in this case INR 42000.But do you think this is the way things pan out? Definitely not. The remaining two members of your group are willing to compromise therefore one of them bids for a lower amount of INR 40000.Seeing this the third member of your group quits from the bidding process. The two members remaining try to outbid each other in a race to the bottom. Finally the lowest bidder in your group gets INR 38000.The organizer who is known as the foreman takes 5% of the total pooled amount which is INR 2500.This amount is deducted from the winner of the bid in your group. The winner gets INR 35500 and the remaining amount of INR 12000 is divided among 10 members of your group as dividends and each member gets INR 1200.The winner of the bid in your group is not allowed to bid again till the passing of the time period. The following month the same process is repeated but now there are only 9 members in your group biding for the same pooled amount which is INR 50000.The dividends differ monthly depending upon the bid amount. The last bidder in your group gets to take the whole chitty after deducting the organizers charges as there is no one else to bid at this stage. Your returns depend upon two factors mainly the organizers charges and the lowest bidders in the pool. The more the number of lower bidders in your group the more amount each of the members of your group get as dividends and the last bidder would get maximum benefits along with maximum dividends. This encourages you to maintain yourself in good financial condition. In the organized sector of chit funds you have the foreman which is a company which takes a percentage of the pooled amount as commission charges. The bidding process in this case consists of the lottery system. The organized sector chit fund has a wide variety of schemes to choose from. Your invested amounts vary from INR 1000 to 1Lakh. Depending on your requirements you can enter into short term or long term schemes which vary from a couple of years to about 5 years. These schemes work in the same way as the unorganized sector. These schemes are governed and regulated as per the Chit Fund act of 1982.The monitoring of operations is very stringent for organized chit funds. Once the chit group commences the foreman has to register the chit with the Registrar of Chits and 100% of the chit value or the subscribers money paid is deposited as a security. This amount can be withdrawn only after the chit fund closes and every subscriber is paid the amounts due to him. This regulation protects the interests of the subscriber.

Infamous Chit Fund Scams In India

You must have heard of an infamous chit fund scam that shook the whole of West Bengal and created a political storm in the Trinamool Congress Government. This came to be known as the Shradha chit fund scam which had no relation to a chit fund but was a Ponzi scheme masquerading as a chit fund. This fund recruited a team of agents promising them 30% commissions, free holidays and land. This company had enormous political clout and made good use of it. These agents through glossy brochures persuaded scores of investors to invest their hard earned money in this scheme promising them returns as high as 15-45%.The agents themselves invested in this scheme because they saw huge returns in their commissions and their standard of life had skyrocketed. These agents who were spotted riding bicycles were now zooming in cars. Other agents saw this and out of greed joined this scheme. Imagine what the ordinary poor investor would have thought when they saw all this? Without a moment’s hesitation they invested their hard earned money into this Ponzi scheme. You must be wondering how these agents and investors were paid? In the beginning there were about 10 investors investing INR 20000 per head promised an interest rate of 25% which they would get at the end of 1 year. Each investor would get a total amount of INR 25000 per year. So How Were Funds Obtained To Pay These Investors? .Agents would find 10 more investors investing INR 25000 to pay off the existing investors. This process continued where old investors were paid off at the cost of the new investor. The fund was flush with cash from the new investors and was used to pay off the agents ,and the promoter of the fund siphoned off huge sums of money. So Why Did The Fund Go Bust?.People stopped investing after a point of time and SEBI was keeping a close eye on this company.The company was asked to pay back all investors or shut operations in three months. What Do You Learn From This?Always study the mechanism of working of the chit fund in the organized sector before making your investment. Know the difference between a Ponzi Scheme and a Pyramid scheme and its differences from a chit fund. You must be wondering why so many people fell victim to this scam. The answer is obvious. Just like a vast majority of the citizens of our country these investors never bothered to study about financial products. I would like to remind you that the team of Financial Planners at Moneymindz.com are always there for you to plan your investment needs in a most effective and efficient manner. You can explore this unique Free Advisory Service just by giving a missed call on 022 6211 6588.

Better Safe Than Sorry

  • In some cases the investor who wins the prized bid makes off with the money and does not contribute his pending share of installments.
  • The group of investors should have the necessary funds to pay their installments so that the operations of the fund are not hindered. Members might be required to maintain a deposit with these funds.
  • There is a risk of the foreman running away with the funds. In order to prevent this from happening to you make sure that the fund is registered under Chit Fund Act 1982.
  • Always go in for registered companies for chit funds and check their past track records in order to maintain the safety of your investment.
  • Always make sure that you have the capability to pay your monthly installments as any default could result in you making huge interest payments and severe penalties.
  • Always check the chit funds you invest in for tall claims such as enormously high rates of return and if there is a statement made that after you get the winning bid no further installments are needed you need to note that they are illegal according to the Chit Fund Act.
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