If you plan to join a chit fund, it’s best to keep off the unregistered ones and stick with registered players of good repute.

Chit funds, an indigenous savings and credit mechanism, are prevalent in many regions of the country. The flexibility offered by these funds to borrow and to save without much paperwork has contributed to its popularity. Businessmen too use chit funds to meet their funding needs quickly.

How they function

Here’s an example of how chit funds generally operate. Say 50 people form a group and agree to contribute Rs 2,000 each month for 50 months - the number of periodic instalments is equal to the number of members in the group. This brings the size of the monthly chit to Rs 1,00,000.

Every month, an auction is held in which the members bid for the chit amount. The person who bids for the lowest amount – by offering the highest discount - is awarded the bid. The discount can range from a minimum of the foreman (fund administrator) commission (up to 5 per cent) to a maximum of 40 per cent.

Say the winning bidder, known as the prized member, offers a discount of 40 per cent. So he gets Rs 60,000. The discount foregone (Rs 40,000) is distributed among all the members of the group after deducting the commission of the foreman. For example, if the commission is Rs 5,000 (5 per cent of the chit amount), the 50 members of the group are entitled to a total net dividend of Rs 35,000, or Rs 700 for each member. This dividend is adjusted against the next instalment which is reduced to Rs 1,300 (Rs 2,000 less the dividend).

Prized members have to continue paying their remaining instalments, and are not allowed to bid in the future auctions. This process continues till the last month with every member winning a bid. Members in urgent need of funds bid earlier by offering higher discounts (availing credit at a cost), while those who can afford to wait bid later at lower discounts (saving for better returns). Returns are not assured and depend upon bidding interest.

Risks and mitigations

Payment discipline by members, adequate security, and proper systems and procedures are some key factors for the smooth running of a chit fund. But chit funds have often been in the news for the wrong reasons. Cases of fraud and embezzlement occur at regular intervals, with members losing large sums of money. What are the risks?

One danger is that a prized member, after winning the bid and taking his money, may not pay his remaining instalments. This puts the non-prized members at a loss and the fund may unravel. The later the person exercises his bid, the higher is his risk.

Delay in instalment payments by non-prized members can also hinder the operation of the chit fund. So, it is important to assess the paying capacity of members before admission into the group. Also, to protect against defaults, chit funds usually require their members to provide adequate security to cover future instalments. Members who delay or default on payments are charged interest and levied penalty.

Another risk, often in the headlines, is that of chit fund organisers scooting with the funds contributed by members. The authorities have sought to mitigate this risk by requiring chit funds to register themselves under relevant laws. They have to keep with the registrar security deposits equal to the chit value.

To further protect the interest of members, registered chit finds are subject to restrictions. They are not allowed to accept public deposits or to invest in the stock market. Being regulated, registered chit funds are relatively safer than unregistered chit funds.

But data suggests that despite laws prohibiting them, unregistered chit funds, which operate among members of informal networks such as relatives, friends or work colleagues, outnumber registered chit funds by a wide margin. This poses several risks to such chit fund members who may find themselves being short-changed and without adequate or timely legal recourse.

Be safe than sorry

If you plan to join a chit fund, it’s best to keep off the unregistered ones and stick with registered players of good repute. A list of registered chit funds is available on the Web site of the Ministry of Corporate Affairs. Make enquiries about the chit fund’s track record. But this may be easier said than done. With chit fund companies being unlisted, there may be little information about them in the public domain.

Importantly, be sure about your financial ability to stay the whole course, else the penalties and interest charges, and security encashment could burn a hole in your pocket. The loss of face will add insult to injury.

Also keep away from schemes which masquerade as chit funds. For instance, funds which exempt prized members from future instalment payments are not allowed by the Chit Funds Act. Be careful to distinguish between genuine legal chit funds and cheat funds.

anand.k@thehindu.co.in

(This article was published on September 22, 2012)
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