What Is Chit Fund: Learn What It Is & How It Works

Chit funds are an age-old financial concept that is popular in India and a few other countries. They function as a unique collective investment, where a group of people come together to pool money for mutual benefit. Chit funds have, over the years, gained much importance, especially in the rural and semi-urban regions, as they are an accessible source of finance for people who are not necessarily being served by the formal banking sectors. 

Though it has become quite popular, there is a misunderstanding over chit funds because of its complexity and potential risk. This article explains what chit funds are, how they function, the pros, the categorization, and the drawbacks involved in investment there.

What is a Chit Fund?

Chit funds are an informal source that effectively provides some financial help to members. They are mainly used for short-term funding, such as sponsoring a business venture or education, covering medical bills, or raising money for a home. The organizer, who may be the chit fund company, oversees the entire operation, making sure everything is done fairly and overtly.

How Do Chit Funds Work?

Chit funds work on a very simple principle of pooling resources. A group of people (usually 10 to 50 members) agree to contribute a fixed amount of money every month over a predetermined period, say 6 months to 2 years. The total sum collected in a month is then made available to one of the members, either through an auction system or by drawing lots.

At the beginning of each cycle, all the contributors contribute their share of money to the fund. In turn, the collected amount is auctioned off, with members bidding for the prize money. The highest bidder usually wins the sum, but at a discounted price (often called the ‘chit value’), which the winning member needs to repay in subsequent months.

Features of Chit Funds

• Chit funds are a form of group investment. The number of participants may be 10 to 50, and these participants agree to pay a fixed sum of money at regular intervals for a specified period.
• Chit funds are usually managed by an organizer or a company that takes care of the administration of the fund. This includes collecting contributions, conducting the auction process, and distributing the prize amounts. The organizer may charge a small fee for their services.
• The one-of-a-kind chit funds characteristic is the bidding process by which the recipient of the pooled amount is determined. Members go through an auction every month, in which they bid for the money. Then, at the end of the auction, the highest bidder takes home the prize, but at a price less than the sum total contributed by all the other participants, and this difference is shared among them as a discount.
• One of the reasons why people find chit funds attractive is because they provide an interest-free loan to the winner. The money collected through the bid is usually paid back in installments during the remaining months of the chit cycle.
• While chit funds offer some security level, they are still a rather risky investment due to the possibility of defaults. In regulated chit funds, however, the risk is relatively lower because of government oversight and legal protections.
• For instance, chit funds in India are regulated by the Chit Funds Act of 1982. This has provided for protection under the law and avenues for dispute resolution and, thus, proper regulations for operating the chit funds themselves.

Advantages of Chit Funds

Availability of Huge Amounts of Money:

Chit funds offer the benefit of a large sum of money, which is being made available periodically to the subscriber for investing in their business, spending on education, or even on assets.

• Unlike loans from banks, chit funds do not levy any interest on the amount borrowed. The only cost to the borrower is the discount received during the bidding process, which is usually lower than traditional loan interest rates.
• Members who win the prize amount can repay the amount in installments over the duration of the chit period, making it an affordable and manageable option.
• Credit funds can be an alternative for people who lack easy access to traditional financial services. It is also a source of credit for many people who cannot get loans from banks or financial institutions.

What are the Different Types of Chit Funds?

Chit funds vary in type depending on their structure, management, and the financial goals of the participants. Here are some of the most common types:

Traditional Chit Funds: These are the oldest and most common types of chit funds. In traditional chit funds, a group of people from the same community or social circle contributes a fixed amount of money on a regular basis. The organizer, who often is a member of the group, facilitates the process of pooling and distributing funds.

Corporate Chit Funds: Corporate chit funds are managed by registered companies or organizations licensed by the government. They pool, bid, and distribute the funds on behalf of the members and charge a small fee for their services. Corporate chit funds are more regulated than traditional ones, providing higher security to investors.

Online Chit Funds: Online chit funds have become popular with the emergence of digital finance. These funds are operated online, and people can contribute to and participate in charity funds from the comfort of their homes. They follow similar rules as traditional or corporate chit funds but use technology to facilitate processes such as bidding and prize distribution.

Specialized Chit Funds: Some chit funds are tailored to specific groups, such as business owners, students, or rural farmers. These funds tailor their loan terms and conditions to meet the needs of the target audience.

Who Should Invest in Chit Funds?

Chit funds can be a good investment for individuals who:

• Chit funds are useful for those who require a lump sum of money in the near future, such as for medical emergencies, educational expenses, or business capital.
• Those who trust their local community or a group of acquaintances may find chit-funds a more accessible and reliable way of saving and borrowing money.
• People who are not able to get loans from banks or other financial institutions because of bad credit scores or lack of collateral may look at chit-funds as an option.
• Credit funds can help develop a habit of regular saving and investment, which may be helpful for people who want to develop better financial habits.
• The most important risk associated with chit funds is the potential for defaulting by participants, particularly in informal or not-so-well-regulated chit funds. In the event that a participant fails to contribute the required amount, other members will bear the loss.
• There is no immediate liquidity. You cannot withdraw your money whenever you want, unlike a savings account, and the funds are tied up until the cycle is complete.
• Chit funds are regulated in countries like India. However, the level of regulation may differ. In a scheme that is poorly regulated, fraud, mismanagement, or lack of transparency could occur.
• If the fund organizer is untrustworthy or incompetent, the participants may lose their invested money. It’s therefore important to choose respected organizers to prevent any mismanagement.

What to Assess Before Investing in a Chit Fund

Before investing in a chit fund, consider the following aspects:

• Reputation of the Organizer: The organizer of the chit fund must be trustworthy and have a track record. There should be an assessment of risk in terms of fraud by the presence of licensed and well-regulated chit funds.
• Terms and Conditions: Read the terms of the chit fund, including contribution amount, duration, and the method of prize distribution, before entering into an agreement.
• Risk and Return Profile: Assess your risk tolerance and whether the chit fund is in line with your financial goals. Determine the potential returns and the risks involved.

Conclusion

Chit funds are an exclusive and usually advantageous financial product that allows individuals to save together, avail of interest-free loans, and bring a sense of community. However, there are risks associated with them, and one needs to be very cautious before investing in them. The more one knows about how they work, their benefits, and their limitations, the better they will be able to make decisions regarding their participation in chit funds.

FAQs

How Can One Join A Chit Fund?

You can join a chit-fund by contacting a registered chit-fund organizer and agreeing to contribute a fixed amount of money regularly.

How to invest in chit funds?

To invest in chit funds, you need to join a group, contribute regularly, and participate in the monthly auctions or lotteries.

How Is The Chit Fund Prize Amount Determined?

The prize amount is typically determined by the total amount collected minus the discount or fees. The winning member receives the prize in a lump sum, and the remainder is distributed among the group.

What are some limitations of investing in mutual funds?

Mutual funds are subject to market risks, have management fees, and may not offer the same level of control over investments as chit funds.

Can A Member Withdraw From A Chit Fund Before It Ends?

Most chit funds do not allow early withdrawal, but some may allow it with a penalty or under specific conditions.