How Does a Chit Fund Work?

A chit fund combines elements of both savings and credit within a structured group. It operates as a collaborative system where individuals contribute regularly to a common pool, allowing members to access a lump sum of money when needed or to save consistently. This mechanism facilitates financial discipline and offers a flexible source of funds outside conventional banking channels.

Core Components of a Chit Fund

A chit fund is a group savings and borrowing system. Each fund involves two parties: the “Foreman” and the “Subscribers.” The Foreman, typically a company or an organized individual, manages the fund, ensuring its operation and adherence to rules. Subscribers are members who join the fund and commit to its terms.

The financial structure of a chit fund involves key terms. The “chit value” represents the total target amount of the fund, the sum of all contributions over its duration. For instance, a fund with 20 members contributing $500 monthly for 20 months would have a chit value of $10,000. An “installment” refers to the fixed, periodic amount each subscriber contributes to the common pool. The “duration” or “tenure” signifies the total period the fund operates, usually corresponding to the number of subscribers.

The Chit Fund Auction Process

The dynamic of a chit fund unfolds through its periodic auction process, typically held monthly. Members who have made their regular contributions are eligible to participate, vying to receive the pooled money for that cycle. The process involves “bidding down” the total prize money, where participants offer to take a lesser amount than the full collected sum. This competitive bidding determines who receives the funds for that cycle.

The successful bidder offers the largest discount from the total collected amount. For example, if a fund collects $10,000, a bidder might offer to take $9,000, providing a $1,000 discount. This discount is the difference between the original chit value and the amount the successful bidder receives. This system provides immediate liquidity for the winning member, who receives the bid amount. Even after receiving the money, the successful bidder remains obligated to continue paying monthly installments until the fund’s tenure concludes.

Participant Financial Flow

After the auction, the financial flow within a chit fund involves the distribution of the “discount” or “dividend.” The amount foregone by the successful bidder is distributed among all other non-bidding members. This distribution reduces the net installment amount each non-bidding member pays for the subsequent period, providing a return on their contributions.

The Foreman receives a commission for services, typically 5% to 7% of the total monthly collected amount. This commission is deducted from the pooled funds before the remaining discount is distributed to members. Over the fund’s duration, each participant either becomes a successful bidder or receives accumulated contributions and dividends at the end of the cycle.

For US taxpayers, any profit from participation in a chit fund, calculated as the total amount received (including dividends) minus total contributions, is generally considered taxable income. This income typically falls under “income from other sources” and does not qualify for tax-saving deductions associated with retirement contributions or certain investments.