Monday, October 26, 2009

Chitty: Self-help financing

Chitty or kurie is a local form of self-help financing. To put in simple terms, the scheme (run by a trustworthy person or financial institute) pools money from a group of people and provides the lumpsum amount to a chosen person in the group (based on a bid or lot), after deducting commissions and charges.

Let us consider an example. Let us take a group of 40 people joining for a chitty worth Rs.1,00,000. The per month value of the chitty will Rs.2,500. For the first month, everyone in the group pays Rs.2,500 as their contribution. One can opt (based on his/ her need) to participate in a lot to avail Rs.70,000 (70% of the pooled in amount) in the first month of the chitty. Out of the remaining Rs.30,000, Rs.5,000 goes as chitty administration charge and the remaining Rs.25,000 is carried forward to the next month. The Rs.25,000 is also virtually distributed equally among the group, by deducting from the monthly contributions for the next month (25,000/40 = 625).

i.e., for the second month, every one contributes Rs.1,875 (2500 - 625), so that the total contribution becomes 1,875x40 + 25,000 = Rs.1,00,000. The procedure of lots continues for the 2nd month onwards and continues till there is no one opting for lots for the Rs.70,000 prize money. The monthly contributions remain the same (Rs.1,875) till this point.

When there is no one opting for lots for the Rs.70,000 prize money, the scheme starts a bid system. The bids would be for any value higher than Rs.70,000 and the individual bid amount would depend on the individual's need for money at that point in time. For example, let us assume that the bid system started on the 10th month and the bid amount was Rs.75,000. Out of the remaining Rs.25,000, Rs.5,000 goes as chitty administration charge and the remaining Rs.20,000 is carried forward to the next month. The virtual distribution for the next month becomes Rs.500 (20,000/40) and the monthly contribution becomes Rs.2,000.

Thus the system goes forward till no one bids for the amount; the monthly contribution becomes Rs.2,500 and the prize money would max out at Rs.95,000 towards the last few months of the chitty period.

Click here for a spreadsheet illustration of the above example.

The benefit of chitty is derived in two ways.

One is when we consider chitty in comparison with a loan. If one becomes eligible for the prize money in the first month's lot, he/ she gets the entire amount in hand. For a loan of Rs.70,000, and a tenure of 39 months, EMI would work out to Rs.2,279 and total payout of Rs.91,381. The average monthly payout in the example that we took is Rs.2,109 and the total payout is Rs.84,375. So a chitty won in the early months work similar to low interest loan. The added advantage is that the paper work and credit history doesn't really matter (but yes, one need to arrange for a guarantor or collateral for the money to be released) in the case of a chitty. This works really well for local businesses and the likes.

The bidding system also creates a chance for savings oriented people where one can adjust the bid amount to maximize bid amounts in the middle months (where the number of bids may be lesser) and then opt for a standard FD to draw a decent interest for the remaining term. A bid at later stages may not be advantageous in later months, but still can fetch a decent lumpsum at the end of the term and work as a compulsory savings scheme.

There are variations of chiities in Kerala and other South Indian states, where local businesses run such schemes for jewelery and other costly items as the prize money.

References: KSFE, atlevg, Maddy's Ramblings

Disclaimer: The views posted in this blog are my own and are based purely on my own way of assessments. Readers are  requested to consult with their financial/ insurance advisers before making any investment/ insurance decision, do their own due diligence and validate factual information.


KSFE Attingal Evening Branch said...

Good post.

We have to say that you presented it better.

One thing about the comparison of chitty and loan schemes.

One cannot figure out the exact overall amount a customer will pay once completing a chitty. You can calculate it in the case of a loan (EMI X proposed number of months). But in the case of chitty, the monthly installment (equivalent of EMI) depends on the auction discount.

However, if you bid the chitty earlier, the overall chitty amount will almost always be less than the total loan amount.

Siraj said...

What is the advantage for a person who takes out the money at the last.. ? IS it better than a fixed deposit for him?

Ganesh said...

I guess i missed Siraj's question on this post. Sorry about that.

There is no specific advantage if one takes money towards the end, other than the fact that he gets the full amount as a lumpsum.

But this would be less than a FD, But it is difficult to figure out as the money is not invested together. More like a recurring deposit. Chitty is best suited for people who can invest regularly per month. For bulk, i guess FD is better.

victim said...

chitty is not a better investment.if you join a chitty ,believe you are on trap many ways.its like a lottery ie if you 100 people join a chitty of Rs 5000 X 100 months,you will be the 100th person,who won the prize.but you will think that you will be the winner of first because you(keralites) are greedy and badly need of others money same and falls on trap.same time if you deposit RS 3750 (after discount) in a month @10%(renew every year)your money will grow to Rs 10000 in 99 months.(remember that you will have to pay in between 3750 and 5000 every month in future) do calculate the rest of 99 months.
then why people join.because of TRAP. NCL,yes ,you will get 50% of sala,soon u join.wait for information on NCL trap

Sreenath Ramanathan said...

What about income tax on interest.., how much percentage is it?

Unknown said...

Hi Ganesh,

I am a bit unclear about the bidding system. Let's say the bidding in the given scenario starts after the 20th month. Is it also possible for a person to bid for an amount lower than 70 percent of chitty amount.