All About Chit funds!

I will show you how chit funds exactly work and what are pros and cons in Chit funds. Over the past many years there have been large scale frauds and scams done by chit fund companies. However, a lot of people do not understand the working and wonder how chit fund works.

Let’s say there are 20 people who come together and form a group. Each one will contribute Rs 1,000 per month and this will continue for next 20 months (equal to number of people in the group). In this group there will be one organizer, who will take the pain of fixing the meetings, collecting money from each other and then doing other procedures.

So each month all these 20 people will meet on a particular day and deposit Rs 1,000 each. That will make a total of Rs 20,000 every month. Now there will be a bid on who will take this money. Naturally there will be few people who are in need of big amount because of some reason like some big expenses, liquidity crunch, business problem, Beti ki Shaadi etc etc … Out of all the people who are in need of money, someone will bid the lowest amount, depending on how desperate he is for this money. The person who bids for lowest amount wins. Suppose out of total 3 people who bid for 18,000, 17,000 and Rs 16,000, the one who bids the lowest will win. In this case it’s the person who has bid Rs 16,000.

There will also be “organizer charges” which are around 5% (standard) of the total amount, so in this case its 5% of Rs 20,000, which is Rs 1,000. So out of the total 16,000 which this winner was going to get, Rs 1,000 will be deducted and the winner will get only Rs 15,000, Rs 1,000 will be organizer charges and Rs 4,000 is the profit, which will be shared by each and every member (all 20 people), it comes out to be Rs 200 per person, and it will be given back to all 20 members. So here you can see that the main winner took a big loss because of his desperate need of getting the money and others benefited by it. So each person actually paid just 800, not 1,000 in this case (they got 200 back). Note that when a person takes the money after bidding, he can’t bid from next time, only 19 people will be eligible for bidding.

Now next month the same thing happens and suppose the best bid was Rs 18,000 , then winner will get 17,000 (after deducting the organizer fees) and the rest 2,000 will be divided back to people (Rs 100 each) . So each person is paying effectively Rs 900. This way each month all the people contribute the money, someone takes the money by bidding lowest, organizer gets his charges and the rest money is divided back to members. You will realize that the person who takes the money at the end will get all the money except organizer fee, as there is no one else to bid now. So the person will get around Rs 19,000 in the end, if you try to find out the returns which he got out of the whole deal, it will depend on two things, how much lower bids were each month and the fees paid to organizer, if bids and charges are very low, then a person will make more money at the cost of other situations.

So this is pretty much how a chit fund works, there are various versions of chit funds and how they work , but the idea was to communicate the basic model and how it works.

Overall, chit funds are not recommended unless it’s a person group formed by friends and relatives whom you trust a lot. I don’t think one should put money with chit funds which are not among their social circle. It might make sense for people in smaller cities to look up to them. As the last note, these chit funds are not investment vehicles where you park your hard earned money, so please avoid them unless you want to exactly take that kind of risk.

Do share your personal experiences about chit funds , I am sure all the readers who are from smaller places , they have seen it and for sure their father or grandfather had used chit funds at some point of time to fund a financial goal.

- Extracts from Jagoinvestor