Investing in Chit Fund a word of caution

 

Investing in Chit Fund a word of caution 

A Chit Fund (Chitty) is basically a contract between the foreman and the Subscribers.  As per the contract, each subscriber agrees to remit a fixed amount of money every month for a number of months.  Chit Fund is a unique scheme incorporating the aspects of a recurring deposit and  loan (cash advance)  In chit fund, the subscriber has an opportunity to bid and avail of cash in advance  which amounts to a certain percentage of the total denomination of the chitty (sala), whereas in recurring deposit the advance can be availed only on the paid up amount.  In case bidding is delayed due to draw of lots in the initial installments, one can resort to availing of chitty loan, which is a loan that "bridges" the gap between the need of the subscriber for money and the delay in the chitty getting prized.

Chit funds are the Indian equivalent of the Rotating Savings and Credit Associations (ROSCA) that are famous throughout the world. ROSCAs are a means to “save and borrow” simultaneously. It is considered one of the best instruments to cater to the needs of the poor. It enables poor people to convert their small savings into lump sums. The concept of chit funds originated more than 1000 years ago. Initially it was in the form of an informal association of traders and households within communities, wherein the members contributed some money in return for an accumulated sum at the end of the tenure. However, in recent times, there have been tremendous alterations in the constitution and functioning of Chit funds.

While in most places ROSCAs are user-owned and organized informally, in India, chit funds have been formally institutionalized as well. Legally recognized firms provide a variety of chit schemes. A Chit Fund can either be legally registered or unregistered. Registered Chit Funds, as the name suggests are being regulated under the various Chit Fund acts. While unregistered Chit Funds are unorganized and mostly run by the close friends, relatives or family members of the investor. Although it is very well known that unregistered Chit Fund industry is very popular in India, mainly in the rural and semi-urban area, where people have very little access to the banking services and where financial illiteracy is more.

The regulation of the Chit Fund industry was put in place by the Government of India to address the problem of misuse of informal Chit Funds by unscrupulous promoters and founders running away with the participant’s funds, leaving the members with little recourse to retrieve their money back. Chit funds in India are governed by various state or central laws. Organized chit fund schemes are required to register with the Registrar or Firms, Societies and Chits. Various Chit Fund Acts governing the industry in India are as under:

  • Union Government – Chit Funds Act 1982 (Except the State of Jammu and Kashmir)
  • Kerala – Kerala Chitties Act 1975
  • Tamil Nadu – Tamil Nadu Chit Funds Act, 1961
  • Karnataka: The Chit Funds (Karnataka) Rules, 1983
  • Andhra Pradesh – The Andhra Pradesh Chit Funds Act, 1971
  • New Delhi- The Chit Funds Act,1982 and Delhi Chit Funds Rules, 2007
  • Maharashtra – Maharashtra Chit Fund Act 1975
  • Uttar Pradesh: Uttar Pradesh Chit Funds Act, 1975
  • Goa, Daman & Diu: The Goa, Daman and Diu Chit Funds Act, 1973
  • Pudducherry: The Pondicherry Chit Funds Act, 1966

 

Who Conducts a Chitty?
            
A Chitty is conducted by a person or an institution and this entity is called the foreman

How many tickets can be enrolled in each chitty?
   
The number of tickets enrolling in a chitty will be equal to the number of months for which the remittance
have to be made or the duration of chitty in months.

What is Chitty “Prize Money”?

The total of the periodic subscription, called the chitty amount, will be given out as “prize money” to the person who bids by allowing for the maximum reduction in the prize money.  The maximum reduction possible is 25% as per the prevailing Chitty Act and if there are more than one subscriber interested in bidding at 25% reduction, the numbers of the such bidders will be put to a draw.  Thus each subscriber gets an opportunity to receive the prize money once during the tenure of the chitty.  All the promoters have to contribute the periodic subscription till the end of the chitty.  The first installment is normally for the promoter, and that is his seed capital. From the second month onwards the total sum will be auctioned among the members. Those who are in urgent requirement of money take part in the auction. The person who is willing to accept the least amount is given preference.

Suppose Total number of members is one hundred and the monthly installment is Rs. 200.00, the total amount comes to Rs. 20,000.00. Member X bids for Rs. 19,800.00 B for 19,500 rupees and C for just Rs.19,000.00, the amount goes to C, but he will get only Rs. 19,000.00. The balance amount for Rs. 1,000.00, on which all members have equal right. That will be given as discount in the payment of next installment. In this example a member has to remit only Rs. 190.00 instead of on Rs. 200.00 as his third installment.  All members are benefited, the benefit of the member C, is that he gets the money in the next month itself. He can tide over the financial problem with ease. Other members get a credit of hundred rupees by remitting just ninety rupees.

Foreman’s Commission

The foreman is entitled to a certain percentage of the chitty amount (not more than 5% of the chitty amount) as his commission from each member


What are the Securities Acceptable for Payment of Prize Money?

The types of security acceptable for chitty prize money payment, belong to various categories like personal sureties (of employees of Government, aided schools, public undertakings, banks etc.), financial documents (like fixed deposits with banks and reputed organizations, Deposit-in-Trust, LIC policies, bank guarantees, National Savings Certificates etc.), landed property or Gold ornaments etc.

Bidding Thump Rule: -

No:1  - As a borrower
Bid the chitty at the maximum rate, since cost of chitty is always much less than the borrowing cost.
 In case you want to take personal loan from the bank or financial institutions, you need to pay annual interest in the range of 15-20%.  But in case of chit funds the cost of money borrowed is much less than the bank loans and more over it is easy and convenient.

No.2  -As an Investor

 In the continuous bidding process, if the discount foregone/available on each month is less than or equal to the proportionate of the gross /maximum discount for the month, bid the ticket immediately and invest the proceeds in high interest paying deposits.

Tips :-

I. Per unit (in % terms) of discount foregone correspond to interest earned on the prize money should be arrived to maximize the return from chitty.

II. Discount forgone in auction should be suitably compensated with the interest/return earned by prize money receipt during the course of the chitty.

 See the following example

Ex :  Mr. X enrolled  for a chitty for a total value (sala) of Rs. 1,00,000.00 for period of 50 months and Rs. 2,000.00 pm as  installments. 

i) If the chitty is auctioned at the 14th month \ installment at a total discount of 10%. prize money payable is 1,00,000-10,000= Rs 90,000.00

ii) Interest accrued on price money deposit for the balance period of (50-14) = 36 months @ 9.5%.
Therefore total interest for Rs 90,000 @ 9.5%(compounded Annually) for 36 months is = Rs 28,164.00

Total prize money received Rs 90,000.00

Total receipt/ inflow from chitty = 28,164.00+ 90,000.00 = Rs 1,18,164.00

iii) If the total dividend earned is Rs 6,000 during the entire chitty period,
The net outflow of the chitty payment is Rs1,00,000 – 6,000 = Rs 94,000.

IV) Net Surplus in chitty Rs 1, 18,164.00 – 94,000 = Rs. 24,164.00

Also applicable service tax is also deducted from the final payment.  In addition to this Forman’s commission (5% - 10%) will be deducted.   Some cases this Forman commission is included in the bid amount.    More over the forman will keep the money minimum one to two months with him before the final payment.

But in reality, the actual net returns received from chit fund is varies from 0% - 8%, in some cases this will be negative also.  It is not advisable to treat chitty as an investment, in case you need money, you can join the chitty and bid at the earliest, your return will come down when the chitty reaches to its maturity.  Even if you want loan, you can avail this from nearby banks.  There are lot of other investments schemes presently available.  Finally the Forman is going to benefits maximum.  So please avoid chitty

Note : above calculation is without considering the Forman’s commission

Income Tax Treatment

·         There two methods to offer the income from chit fund to income-tax a) First Method: Offer the dividend you receive from month to month to tax b) Second Method: Offer the difference between the amount you paid and the amount you received to tax if the amount received by you is greater than the amount you paid. If the amount you received is lesser than the amount you paid it is a loss

The second method can adopted only after completion of the chit. Till then the amount paid by you is treated as investment and if you bid and receive the bid money the money received by you is treated as an advance/loan in the books of account (in case if you maintain books of account)

If you contribute the chit out of the business funds for the purpose of the business the loss incurred on bidding or on closure of the chit (in case the money received is lesser than the money you paid) the said loss can be treated as business loss

A word of caution: Of late some crooked elements got involved in to this business and polluted it to the extreme. Some promoters disappeared with members’ money, and in other cases some members disappeared after accepting the money.  You have to be very careful while selecting the chitty company. You can find chitty companies everywhere. When you deal with chitty companies, go for those companies promoted by reliable persons with sound track records.  Don’t put your hard earned money based on some attractive TV advertisements of film stars or other celebrities offering valuable gifts like luxury cars, luxury villas or foreign trips etc. 

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