I have never understood chit funds. I still don’t. But I have heard great things about the returns on them, so thought I should learn about them from a friend who knows a great deal about chit funds. So thanks to him, I have some data that I collected and decided to check if they are a good investment. Remember that I only have very cursory information and you should not take my advice without doing your own research. I am presenting all the data as I received from my friend and as such I don’t really know any chit funds which offer similar schemes. I do not have any investments in chits, nor will I invest in them in the foreseeable future. But things can always change and if I do invest in them, you will know about it from my blog.


Before talking to my friend, I never understood how chit funds could be profitable. From all the articles I read online, a chit fund works in the following way. A group of people pool their money every month. Suppose there are 10 individuals and each invests Rs. 10,000 in a month. The total comes to Rs. 1,00,000. Then, they run an open auction to find the lowest amount a person within that group is willing to take. Suppose in our example, one of the 10 members who is in dire financial need wants to take Rs. 90,000. Then, they take the amount that month and the rest of the 9 members get benefit from the Rs. 10,000 that is left over.


Since there is never a free lunch, the person who is running the fund takes a fees. Suppose in the example, they take Rs. 1,000 as the administration fees. Then, the left over Rs, 9,000 can be distributed among the rest of the members as dividend. So each of the 9 members who did not win the auction get Rs. 1,000 each. This continues every month and each member is expected to participate in the auction at some point or the other. So in 10 months, all the 10 members would have taken the investment in some month.


That is the usual explanation of chit funds which is given when I search online. But you can easily do the mental accounting and figure out that no one is actually gaining. No one is making a profit since every one has to participate in the auction and the money is never invested anywhere. If anything, it is a loss making proposition for everyone but for the person who is organizing the auction. So why would anyone invest in chit funds? That has always been my question which no one could answer. The only reason anyone would want to participate in chits is if they think they will need money all of a sudden. Then why not save the same Rs. 10,000 every month in a bank (ala emergency fund) and use that in case of emergency?


It is not as simple as that though. There are some members who are benefiting too. If you use system 2 thinking, you know that each person gets a different return on investment. The person who takes the money the earliest, stands to gain the most in some cases. Say, in the above example every person takes Rs. 90,000 in the month that they need money, then the person who took the money in the first month took a loan with an interest rate of 3% while the person who takes the last has a return of -2.95% from their savings account. Let me explain starting with the person who took the money first.


Month Person 1
1 80000
2 -9000
3 -9000
4 -9000
5 -9000
6 -9000
7 -9000
8 -9000
9 -9000
10 -9000


Think of it this way. The person who first takes out the money is in effect taking a loan of Rs. 80,000 on the first month. How? Because they invested Rs. 10,000 that month and took Rs. 90,000 from the total sum. From there on, they are paying an EMI of Rs. 9,000 every month for the next 9 months. How? Well, they need to invest Rs. 10,000 every month, and they are getting back a dividend of Rs. 1,000 because someone else in the group took Rs. 90,000 (in this example), Rs. 1,000 is gone in fees and the rest Rs. 9,000 is distributed as dividend. So, this person paid Rs. 10,000 and got back Rs. 1,000, effectively making it a Rs. 9,000 EMI. They paid Rs. 81,000 in the end for a Rs. 80,000 loan. That is a pretty good loan interest rate if you ask me. For the person who takes money last, it looks like a savings account.


Month Person 10
1 -9000
2 -9000
3 -9000
4 -9000
5 -9000
6 -9000
7 -9000
8 -9000
9 -9000
10 80000


Basically, this person was investing Rs. 9000 in the bank every month for a total of Rs. 81,000 and got back Rs. 80,000 in the end making it the worst savings account. Their return on investment is -2.95%. So some benefited and others did not, but on the whole everyone lost money. This is in theory at least. Of course different people will take different amounts in the open auction making it hard to predict. But there is one person who is making money who is the organizer. So when you hear about chit funds, I assume, you invest in the fund, but never participate in the auction actually. You are just lending out money to someone and making profit out of the fees.


My understanding is that once the chit fund investors invest some money in a month, the money is pooled and probably given out for micro financing possibly in unorganized sector. As a result, the return on investment could be high, but at the same time, the risk of default is also high. Anyway, my friend shared a couple of schemes and the returns on them is really very high. Since he knows the person running the chit fund, he says there is very low to no risk. Here is one scheme’s structure.


Month Amount
1 ₹ 17,500
2 ₹ 17,850
3 ₹ 18,200
4 ₹ 18,600
5 ₹ 19,000
6 ₹ 19,400
7 ₹ 19,800
8 ₹ 20,200
9 ₹ 20,600
10 ₹ 21,000
11 ₹ 21,400
12 ₹ 21,800
13 ₹ 22,200
14 ₹ 22,600
15 ₹ 23,000
16 ₹ 23,400
17 ₹ 23,800
18 ₹ 24,250
19 ₹ 24,700
20 ₹ 25,000
Receive -₹ 480,000
Returns 15.79%


You are investing some increasing amount each month for a total of Rs. 4.24 lakhs and after 20 months, you get back Rs. 4.80 lakhs. The XIRR turns out to be almost 16%! That is an excellent investment especially if it is a risk free investment like my friend says (in his case). Way better than the 6% risk free rate of FDs currently and better than risk adjusted returns on equity. If you know of such a scheme with no risk, feel free to invest. As for me, I don’t know any such schemes so I never invested, nor will I do so in the foreseeable future.