The concept of chit fund is ancient to India and over the years it has become a popular tool, especially for business owners and traders. It’s a platform that brings together savers and borrowers who commit to contribute or invest a fixed monthly sum for a fixed period of time.
The subscribers generally see this scheme as a win-win and the reason for its popularity is:
- Convenient credit and easy access to money: The subscriber gets access to a much higher amount (which is the total chit value-foreman’s commission-discounted rate) for a far lesser amount saved by him/her on a monthly basis.
- While on one hand when the borrower gets the money he needs urgently (a quick loan), on the other hand, the other members get to pay an amount lower than the original amount agreed upon (better returns on their investment in the chit).
- It also serves as a platform for regular savings and practising monthly financial discipline.
- It gives a picture of getting ‘higher returns in the end’.
From outside, a chit fund option may seem as one of the best options to invest your money in. However, every coin has two sides to it and chit fund may also be one of the most dangerous and a silent debt trap, the awareness of which is not much.
FIVE WAYS IN WHICH CHIT FUND CONTRIBUTES TO YOUR DEBT:
- Easy access to money can be harmful at times if you don’t know what to do with it. Very few use it to expand their business but most people spend the money on their lifestyle expenditure. An increase in lifestyle expenditure opens doors to financial indiscipline and increases other costs also along with it.
- A chit fund company at times pushes its subscribers to withdraw money before itself (irrespective of whether the subscriber wants to withdraw or not) in order to pass on the benefits to other subscribers. The foreman does this to create a higher value for other subscribers and also to benefit from the commission. In this situation, the person who bid stands at a loss as in the end he may have paid more than what he would’ve received.
- At times it happens that a foreman chooses a subscriber as a bidder by drawing a name from a lot. This happens when most or all the subscribers are interested in savings and hence they may not want to go for a bid. Therefore the subscriber gets the chit fund, as fixed by the foreman, when he doesn’t need it. This result in unwanted surplus and if not guided properly, the subscriber indulges in quick spending.
- The return on chit may seem high. However, if you have taken the money before itself by way of winning an auction or bid, you would notice that in the end you have paid more than what you’ve received. Therefore, your returns are not fixed, they may vary depending on when and how much you bid for.
- Chance of fraud is high with almost no investor protection. There is always a risk that the subscriber after winning his bid may default in paying the future instalments or that the foreman runs away with the corpus amount. This has an impact not only on the profits made but also on your capital. Although the chit fund company may be registered, the investors have no protection either from the government or the RBI.
ACTIONS TO TAKE BEFORE INVESTING IN A CHIT FUND:
- Before investing in a chit fund, check if the said chit fund company is registered or not. Next, check if the promoters of the chit fund company are financially sound.
- Another precaution to take is to check if there is any pending case against the chit fund company. This is important to assess the degree of risk that you may be getting into if you decided to invest in the chit fund.
- Find out the foreman commission and go for chit with lowest commission as this highly impacts the returns that you’re entitled to get in the future.
- Check if you can regularly pay the monthly instalments.
- Since the risk of default in monthly instalments is high, go for such a chit fund where you know the other subscribers and there’s mutual trust.
- Calculate the IRR, CAGR, effective rate of interest on borrowing before taking decision to invest.
In my opinion, a chit fund is a potential debt trap and such an option is not advisable for a working employee as the returns are generally low and the cost on capital high. If you want to go for a chit fund then it’s advisable to invest in such a chit fund in which the other subscribers are known people whom you trust. The chit fund option could be used by business owners who are aware of their profit margin and know their risk appetite.