How Does It Work? The Financial Logic
A chit fund is a savings-cum-borrowing scheme wherein a few people (known as members or subscribers) come together and invest a fixed amount every month for a fixed period. Some say that it’s a personal loan, a recurring deposit and a kitty party rolled into one.
The number of months for which the investment is made is the same as the number of subscribers in the scheme. Every subscriber gets a turn to take the total amount collected in a month; this means in every month one subscriber will get the collected amount. The subscriber to get the money will be decided based on either a lucky draw or a bidding system, the latter being the popular option. Once a subscriber gets his turn, he is not allowed to participate in the bidding again. Generally, those who are in need of money in a particular month participate in the bidding, and the subscriber with the lowest bid is allowed to take the amount. The chit fund scheme is managed by one of the members, known as the foreman. He is responsible for collecting the subscription amount from subscribers, recording details of members and conducting the auctions. For these duties he is paid a fee, which is generally five per cent of the amount collected. The foreman’s fee is reduced from the amount paid to the subscriber who wins the bid. Any extra amount from the monthly collections is distributed equally among all the subscribers. The chit-fund companies are basically the foreman.
Assume there is a chit fund with 10 members/subscribers contributing Rs 3,000 each per month for 10 months. The total monthly collection in this chit fund is Rs 30,000. Suppose in the first month there are two members who need funds and participate in the bidding. One member bids for Rs 27,000 while the other member bids for Rs 26,000. The second member becomes eligible to draw the money for the month as his bid is lower than the first member’s bid. (If there is more than one member bidding for the same lowest amount, a lottery is drawn to determine which of the members will be eligible for withdrawing the amount.) In this illustration, the second member can withdraw Rs 24,500 (subtracting foreman’s fee of Rs 1,500, which is five per cent of Rs 30,000). The remaining Rs 4,000 (Rs 30,000 – Rs 26,000) is distributed equally among all the members – so each member gets Rs 400 each. So in effect, during the first month each member contributes only Rs 2,600.
In the second month, another member is given a chance to withdraw the bulk amount. Suppose this member bids for Rs 28,000; so the remaining Rs 2,000 is divided among the members – that is, Rs 200 per member. This process is repeated every month for a total of 10 months. On the completion of 10 months’ period, each subscriber will have withdrawn a bulk amount once, in addition to getting the monthly nominal amount. This monthly amount works like a dividend for the money invested and is comparatively higher than the bank interest (FD rate) that gets accrued in recurring deposit schemes of commercial banks.
Rules for determining which member takes the bulk amount every month and also the withdrawal amount vary from one chit fund to another in different states. However, they all have to abide by the Chit Funds Act 1981.