A chit fund is a collective instrument tool where there are two participants, one is the organizer and the other is the member. There are various members who collectively come together and agree to pool-in a specified sum of money every month for a fixed duration.
For instance, say there are 24 members who agree to deposit Rs. 5000 every month for 24 months. So, in the first month, all the 24 members deposit Rs. 5000, which amounts to a total of Rs. 1,20,000 (24*5000).
The money so collected every month is then up for auction for any member who needs it immediately.
The organizer holds an auction where all the members participate and those who want the collected money (known as ‘the pot’) bid for it. By bidding it means the member agrees to forego some part of the money in order to claim the pot. The lowest bidder gets the pot, i.e. the one who is ready to forego the most. The Chit Funds Act, 1982 has put a cap on how much can a member forego, which is 30% at max.
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. A 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 winner of the auction is C because he has bid the lowest i.e. he is ready to forego the most.
So, the lowest bidder takes the pot after deducting the organizer charges which is 5% at max.
Since C has bid for Rs. 100,000. He will get the money after deducting the organiser 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 foregone by the winner of the auction is then distributed among the rest of the members, which is called the ‘dividend’. It is not received in cash but is deducted from the monthly installments that the member has to pay. Therefore he pays less than his actual installment.
The amount foregone by C is 1,20,000-1,00,000= 20,000. This Rs. 20,000 will be divided among the all the members as ‘dividend’ which amounts to Rs. 833 per person. It won’t be paid, but will be adjusted from their monthly installments i.e. from Rs. 5,000 and they would only be required to pay the balance 5,000-833= 4167.
Thus, the revised installment amount is Rs. 4,167 for the same pot value of Rs. 1,20,000.
After the auction, the winning member still has to pay the remaining installments.
Here, C has won the auction but he will continue paying the installment every month until the end of the tenure which is 24 months.
The same process is repeated every month until all the members have got the money once. A member who has taken the money once cannot participate in the auction thereafter.
Here, since C has claimed the pot in the first month, he cannot participate in the auction in subsequent months.
If in any month there are no bidders in the auction, then a member is chosen by lucky draw and he gets the entire pot after deducting the organizer charges.
So this is how a chit fund operates.
Unorganised and Organised Chit Funds
Although there is a law governing the chit funds but still there are a lot of ‘kitty’ and ‘committees’ who operate on the chit fund model but are not regulated. This is the unorganised sector of chit fund. They can have their own modification in the model. Be it in depositing of installments or withdrawal method, unorganized chit funds customize according to their convenience.
Then again there is an organised sector which is operated and regulated according to the law and are regulated by the Chit Funds Act, 1982. There are very few companies who operate in the organised sector such a Shriram Chit Funds.
After the Saradha Scam in 2013, many people have lost faith in the chit fund scheme. Since even after the regulations there is a huge inherent risk of defaulters and organizer’s authenticity. The Act came into force in 1982 but the scam was exposed in 2013, which clearly reflects that even with the law in place, it is not stringent or regulated enough making chit funds a highly risky affair. Nevertheless it is still popular in the southern states.
Tax on Income from Chit Funds
The dividend income earned per month is neither tax deductible nor taxable.
The overall income is taxable as income from other sources.
The overall loss can be claimed as business loss.
For instance, if a member at the end receives Rs.1,30,000 instead of Rs. 1,20,000, then the excess of Rs. 10,000 is taxable as Income from other sources.
If he receives Rs. 1,10,000 instead of Rs. 1,20,000, then the difference of Rs. 10,000 can be claimed as a business loss.
Should you invest in Chit Funds?
Chit funds serves both as an investment as well as a borrowing tool. The members who are in need of money can bid for the Chit Fund in the initial months and get the whole pot.
The members who are not in need of money usually prefer to take the pot at in the later months and therefore make more money.
This how Chit Fund works by connecting the borrowers with the investors. Chit Funds used to be popular earlier but they have lost their charm in the past decade. Increase in the number of Chit Fund scams is one reason why people are now shying away form Chit Funds.
Moreover, the income earned by the investors is also not lucrative enough and is not worth taking so much risk. For the borrowers, as well there are now so many banks and NBFC’s who are willing to lend without collateral that it does not make any sense for people to use Chit Funds as a borrowing tool.
The number of formal channels for borrowing and lending have increased in the past few years which has also resulted in people shying away from Chit Funds.