How chit fund works : Explained with 9 Stages
What is a chit fund and how it works ? This is a question I asked myself when I first heard my colleagues talk about this.
I got a vague idea first – It is some form of investment and there is a monthly instalment. That’s it!! Nothing else was clear to me. Every explanation made the idea more and more complicated to me.
They talked about commission, chit amount, auction, bid amount etc….
Then one day I decided to spend enough of time to understand its complete working. And that’s exactly what I did. Now it’s my turn to explain it to every new investors the working of chit fund in 7 easy steps and one single example.
Let’s dive in.
What is a Chit Fund ?
In simple terms, chit fund is a financial tool that allows investors to take loan through bidding with minimal paper work. So, if a bank loan is not accessible for an individual this chit fund will be a good alternative.
That means, access to loan is the primary purpose of a Chit fund. Being a means of investment, expecting a profit, is only a secondary use of Chit fund.
Unfortunately, most people assume that Chit Fund is primarily a means of investment – like FD in Bank or Mutual Fund. That’s wrong.
Why chit fund is not a good investment option is clearly explained in a separate section below. But before going there, let’s see how a chit fund works
Working of a Chit fund
This is the main section. Let me explain the working using an example.
#1 Purpose
Let’s say that I am a shop owner. I am planning to renovate my show. For that I need 5 Lakhs.
The good thing is that, it’s not urgent. It’s fine even if I renovate the shop any time this year. But sooner the better. Unfortunately, I don’t have that much amount now. Each month I can save only 10,000 from my income.
So for saving up 5 Lakhs, I have to wait around 4 years!! I can’t wait that long. So I approached a bank.
Sadly bank say’s that I am not eligible for loan. Now what can I do ?
#2 Group of People
That’s when I heard few other shop owners also face this same problem. They want loan but bank rejected them.
Not just them. My neighbor is about to get married next month. They also need some fund for that. Also, I have an uncle who needs some fund for buying castles.
In total there are 50 of us. We decided to form a group. Why ? Because we got an idea to generate the fund!
#3 Idea to generate fund
I called everyone and explained the idea.
In the beginning of each month each one of us will give 10,000Rs to one person in this group. We will call him the Fund Manager.
Thus each month this Fund manager will have 5 lakh rupees.
Now the Fund Manager should give the fund to the one member who needs the fund the most, that month.
But how to identify that person ?
Chit Duration
Each Chit Fund will be for a specific duration of months. Total number of months will be equal to the total members in the chit fund. This will give each member a chance to get the bid amount.
E.g.: If there are 50 member, then duration will be 50 months.
Monthly Instalment
Instalment is the amount paid by each member, each month. This is excluding any discounts that you will get.
E.g.: 10,000 in the above case
Chit Amount
Chit Amount is the total amount you will get once the chit ends. This is the same amount available for auction each month.
Chit amount = Number of member * Monthly Instalment
E.g.: 5 Lakh in the above case
#4 Auction
Using auction the Fund Manager will identify the member who want’s this fund the most.
In the auction or bidding, the members who need the fund that month will tell an amount they are willing to pay to get this fund.
Alright. I need the fund. So I will participate in this auction. My neighbor and uncle is also there for marriage and Farming. Uncle said “I will pay 1000 for this fund”.
I thought that if I had taken this 5lakh from bank, I have to pay 10% interest, which is 50,000. So without any issue I can pay up to 50 thousand.
I had a Chit Calculator in hand while doing the bidding and I calculated the interest for each bid amount I am calling.
So I said I will pay 2000. Give the fund to me. Suddenly my neighbor called 3000. This way the bidding went on till the bid amount went till 50,000.
Then I thought “This 5 lakh is not urgent for me. I can do the renovation next month as well. What if there are not one else next month for bidding. Then might get this 5 lakh by just bidding it for 1000. So I stopped bidding.
However, it went on between uncle and neighbor till the bid amount reached 1 lakh. That amount was called by my neighbor . Because my neighbor needs that 5 lakh urgently. At that point my uncle stopped bidding a higher number.
Thus my neighbor won the auction. He can’t participate in any future auctions.
He will now take the 5lakh home by paying this1 lakh. Thus he gets a net of 4 lakh.
Each month every member will pay the instalment amount.
The person who won the auction will pay this instalment amount just like others. On top of that he/she will pay the bid amount, that month.
Chit Interest Calculator
For finding the interest rate corresponding to each bid amount, and to decide when to stop bidding use a good Chit Interest Calculator.
#5 Commission
Now what to do with the 1 lakh my neighbor paid ?
The Fund manager said that he is taking a big risk. So he needs 5% as commission for his work.
What the risk for Fund Manager ? If my neighbor who went home with the chit amount refuses to pay the remaining months installment then it is the Fund Managers duty to put that 10000 each month, on behalf of my neighbor, who did the fraud.
Okay. Out of the 1 lakh, 5% of 5 lakh, which is 25000 will go to the Fund Manager.
75000 is pending.
Amount you will get
Every member will get the final chit amount only after deducting the Commission.
#Case 1 – Never participate in Auction
If you never participated in any months auction, then by end of the chit duration you will get the chit amount after deducting the commission.
Amount receivable = Chit amount – Commission.
Eg: In this case, chit amount is 5 lakh. It’s commission is 5% of that I.e. 25000. So you will get only 475000.
#Case 2 – Participate in Auction
On the other hand, if you participated in auction (possible only once), that then month itself you will get your Chit amount. You won’t get anything else when the chit period ends.
Amount Receivable = Chit amount – Bid Amount
Bid Amount can’t be lower than the Commission. If it is lower than you will have to pay the Commission as the Bid Amount.
#6 Discount in next month’s instalment.
The rest 75,000 will be shared equally to all the members.
Each person will thus 2500. This 2500 is the monthly profit. This can be considered as the interest earned.
We decided that instead of talking this 2500, let’s reduce this amount from next month instalment. Thus next month everyone will pay an instalment of only 7500.
The monthly discount in instalment is the profit or returns from Chit Fund. This is similar to getting a monthly interest from a Fixed Deposit in the Bank.
This discount will increase if the final bid amount is more, and vice versa. Each month the final bid amount will vary. Thus we can’t predict the discount in instalment in advance.
#7 Last few months
On the 45th month no one participated in the auction. They though “there are only 5 more months pending”. Why should I pay a bid amount just for getting the 5 lakhs, 5 months early.”
Since no one bided, there is no bid amount to distribute as a discount. Thus every one paid the whole instalments in the last few months.
Normally the discount will be high during the initial months of Chit. Then it start dropping as people will only bid for a lower price.
#8 Never participated in bidding
Few months after I joined this chit fund, I changed my plan to renovate the shop. So I don’t need to get the chit amount any time sooner.
That means I don’t have to participate in bidding and pay any amount for getting the 5 lakh early.
Once the 50 months ended. I got my 5 lakh.
Remember, there will be a deduction of commission. So what you will receive in hand will be 5 lakh minus 25000 = 475000.
#9 Calculate total returns from Chit Fund
I added up the total amount I paid though the 50 instalments. It is only 4.6 lakhs, not 5 lakh. Because each month I got a discount due to other’s bidding.
By end of the 50 months, I got 5 lakh minus the Fund managers commission, which is 25000. This results in 47500.
So my total returns or interest from this chit fund is 15,000.
To summarise:
- Amount I received by end of the Chit Duration = 5 lakh – 5% Commission = 4,75,000.
- Sum of my monthly payments = 4,60,000
- My Profit = 4,75,000 – 4,60,000 = 15,000.
How to calculate the total returns from a chit fund ?
We can calculate the total returns from a Chit Fund only after the chit fund ends. We can’t do that in advance.
For calculating the total returns,
- First, add all the instalments paid. This is your total investment.
- Then subtract the Fund Managers commission from total Chit amount. This is your returns.
- Finally, subtract the Returns from the Total Investment.
Hope you are clear with the working of Chit fund. If you have any questions please ask in the comment section.
Now let’s see some special cases.
Special Scenarios in Chit Fund
Scenario #1 : No one participated in the bidding in any month.
In such a case, you will have to pay the complete Chit amount, though multiple instalments. But you will only receive this amount back after deducting the commission.
So if the Commission is 5%, you will make a loss of 5% when the chit fund ends.
However this scenario is unlikely. Because if no one is bidding, you can bid in the first month itself and get this final amount in the beginning month itself. Then you can invest that in a bank as a Fixed Deposit and earn interest from there.
Scenario #2 : Someone got the chit amount through auction and refuse to pay the remaining instalment.
This is a fraud. There will be legal action against that person.
Also this is a main risk of Chit Fund. IF the chit fund Manager don’t have a cash reserve then he won’t be able to pay the Chit Amount in future auctions and at the end. Eventually the Chit will fail.
Scenario #3: Chit lottery
In some chit fund, each month along with auction there will be a lottery. The person winning the lottery will get the Chit amount (after commission), in the current month itself.
For example, if it’s a 50 month chit fund and you win the lottery in the 2 month. Then unlike auction you are not paying any price for getting this chit fund early. Great!
You can pay that amount in bank and earn extra interest on that for rest of the 48 months.
Now let’s see if Chit Fund is a good investment.
Chit Fund Vs SIP Vs FD
Many people consider Chit Fund as an investment, not as a means to get loan. For those people the alternate options are SIP in a Mutual Fund and Fixed Deposit.
Historically Mutual Fund SIP will bring more returns than a Chit Fund. Because in chit fund the commission percent will reduce the effective profit.
The effective returns from chit fund is approximately 8% to 10%. Whereas, in Mutual Fund SIP it’s 12% – 18%.
On top of this the security is more in Mutual Fund, since all Mutual Funds are regulated by SIB.
On the flip side, there are many non- registered Chit Funds.
Mutual Fund SIP and Chit Fund both has an uncertainty in the returns.
If one needs know the percentage of returns in advance, then Bank Deposit is the alternative. However we can’t compare Chit Fund with Fixed Deposit (FD).
In Fixed Deposit it’s a one-time payment. So the one closer to Chit fund is a Recurring Deposit.
Recurring deposit involves monthly instalment and getting a bulk amount at the end. But, here the return is pre-determined. So the guaranty is there.
However the returns in RD will be lesser than Mutual Fund SIP
Now let’s see how chit fund performs as a means to get loan.
Bank Loan Vs Chit Fund
Compared to Bank loan Chit Fund is a good alternative. The ease of getting a loan is much better in a Chit Fund.
Only make sure that while participating in the Auction, decide the bid amount you are willing to afford in advance. You can use calculators to find the bid amount and interest of a Chit Fund.
Conclusion
Chit Fund is a good option to get a loan though bidding. However, purely as an investment, the strength of Chit Fund is questionable. Either way I hope that you are clear on the working of a Chit Fund.
If you have any question or feedback, share those right below in the comment section.
Good Day.
Happy to listen to your thoughts