What are chit funds? Should I invest?

Closed system, where someone's gain is another person's loss. Does not scale with corpus size. Has little to no regulatory oversight. Stay away. Also called as chit, kitty, chitty, kuri, etc.

How does a chit fund work: ELI5 version

It is a savings plus credit / loan product. There is an organizer (a.k.a foreman) and there are a specified number of members, who agree to pool/pay/deposit a specified amount of money periodically for a pre-decided fixed duration.

E.g. there can be a chit fund with 20 members (and a separate 21st organizer who conducts the whole show), and they agree to pool Rs 1000 every month for 20 months. So, a fixed number of members, periodic deposit monthly, deposit amount of rs 1000 and fixed total period of 20 months. In the first month, the total amount of deposit would be 20,000.

This total monthly amount is called the Pot/Prize/Kitty. Each member, either by lot or by auction, will be entitled to this prize/Pot amount. The lowest bidder (one who demands the least amount) will get the money after paying the organizer fees and rest of the money will be distributed among the members. The lowest bid can be up to a discount of 40%. The distribution is usually by way of decreasing the monthly amount.

Eg. if selection is by auction, and there are only two members (A and B) who want money in this month, then they can bid for anything less than 20,000. If A says he is ready to take the pot for 19k (he will leave 1000 for the rest of pool provided he gets the money right now) and B says he is ready to take the pot for 18k, the winner of the first month will be B. The foreman will deduct the organizer money (maximum of 5%, in this case 5% of 18,000 = 900) and give 17,100 to B. The remaining amount of 2,000 will be distributed equally among the 20 members, by way of this month's monthly instalment of 900 (and not 1000). In this case, the lowest allowable bid would be 40% lesser which would be 12,000.

Every month the same process goes on. Members who have taken the Pot in the previous months cannot bid again during rest of the chit fund period. And every month, depending upon the amount of final lowest bid, the monthly instalment gets decreased.

If there is no one to auction in any month, then a lucky draw is done and the entire pot, after deduction the foreman fees, is given to that member.

Types

Organized Chit Funds

There is a central govt Chit Fund Act 1982 and multiple state government chit fund acts, which govern the organized chit funds. Nowadays, there are online chit funds also with different prize groups and ability to pay/receive payments online.

Unorganized Chit Funds

And there are lot of local chits/kitties/committees, which have their own particular models of deposits and withdrawal systems.

Tax on Income from Chit Funds

The dividend income earned per month is neither tax deductible nor taxable. No TDS applies on them.

The overall income is taxable as income from other sources.

The overall loss can be claimed as business loss.

E.g. if a member receives Rs. 22,000 instead of Rs. 20,000, then Rs. 2,000 would be taxable as Income from other sources.

While if a member receives Rs. 18,000 instead of Rs. 20,000, then the difference of Rs. 2,000 can be claimed as a business loss.

Benefits of Chit Funds

Those members who are in need of money (for small business, marriage, construction of house, big expense, etc ) can bid for the Pot in the initial months and use that money for their own purposes. Effectively, it works as an advance loan for them with EMI-like payments in the later months.

While those members who are not in need of money prefer to take the pot in the later months, and therefore make more money. They get lumpsum money while saving smaller periodic amounts.

In short, chit funds connect loan seekers with savers with the foreman as the person who guarantees the transfer of money. It is an overall less than zero-sum game, some member lose money while others gain money, while the foreman takes his payout.

Risk

Both the foreman and members are exposed to credit risk since the members can default on their payments, either before or after getting the prize. The foreman can sue the defaulters in court but timely settlement is a problem. Many foremen require some form of surety by members who have won the auctions. There is no bank/govt insurance for the chit fund payments, so it is riskier than bank deposits.

So if one sees that parents, or friends or relatives have earned a lot from chit funds, then they should understand that the above-FD returns are because of taking on the credit risk which may or may not occur in future. Consider your own risk appetite and financial situation before putting money in a chit fund. If you still want to take such a risk, at least go by organized reputed chit fund groups, and not local unorganized ones.

Red Flags

1. Promise of high returns: Chit funds cannot promise return rates in advance, and if any of them does it, it is better to run away. They cannot do so because no one can predict at what discount would the members bid for the prize money during the entire duration of the chit fund.

2. Unregistered: Please don't. You will have no recourse to get any money if there is any default.

3. Incentive to get new members: If the chit fund offers any incentive to get new/additional members, then it is outside the normal rules of the chit fund and is likely to be a Ponzi scheme. Run.

4. Allows to stop future instalments after getting the prize money. This structure is also against the basic chit fund system, and should make you think of what else? Run.

5. Online unknown chit fund schemes. Go only with groups backed by large groups/state governments who have been doing proper rule-based chit fund schemes. Don't entertain small unknown groups.