What Is the Set-Off Clause?
What is a set-off? A set-off clause is a financial agreement that effectively removes unnecessary back and forth payments between two groups. Consider the example of two banks that owe each other for various debits. They would ask, who owes the most money? Is any money owed to them? If so, subtract that amount, and the net difference is the final bill.
The set-off clause gets a little more complicated, however, when applied to banks, borrowers, and outstanding debts. In essence, the set-off clause allows banks to draw from deposit accounts when a debtor owes them money.
Keep reading to explore details of the set-off clause and how it’s used in the everyday world by financial institutions.
Key Points
• Set-off clauses allow financial institutions to reduce mutual debts by applying funds from deposit accounts.
• Banks can use set-off to cover unpaid debts without always notifying the borrower.
• Set-off actions do not impact credit scores and have a neutral effect on creditworthiness.
• Borrowers can protect against set-off by understanding and negotiating agreement terms or switching banks.
• Debt consolidation through a personal loan can offer lower interest rates and simplified payments, avoiding set-off risks.
Understanding the Set-Off Clause
The set-off clause is a financial agreement made between two parties that allows one group’s debt obligation to be offset by the other group’s debt obligations to them. If two groups both owe money to each another, the one with the largest debt pays the difference between the two debts.
All in all, its purpose is to remove unnecessary payments between two parties. However, the set-off clause is often invoked by banks and financial institutions when a debtor defaults on payments on a loan product or owes an outstanding balance.
Definition and Purpose
Set-off legal definition: A set-off occurs when there are mutual debt obligations between two parties, but one party’s debt is reduced by the amount the second party owes to them.
The original purpose of a set-off clause is to reduce the amount of unnecessary back and forth between two parties. But when it comes to financial institutions, there are many reasons for its existence. One purpose is to provide stability to banking institutions. Because loans are essentially secured through deposit accounts, banks can continue to operate without fear of liquidity issues.
A simpler purpose is that it makes collecting debts a lot easier and faster. Of course, there are many types of debt, which may determine how remittance is pursued.
How Set-Off Clauses Work
Set-off clauses may be invoked by financial institutions when a borrower has checking or savings accounts with the same lender they have a debt with. Should they overdraw or owe unpaid fees to the lender, the lender has the right, via the set-off clause, to pull money from the borrower’s deposit accounts to settle unpaid debts.
Depending on the agreement and local laws, the lender or bank may not even have to notify the borrower when the clause is invoked.
Where You’ll Encounter Set-Off Clauses
You’re likely to find a set-off clause with credit cards, loans, and even bank account agreements.
For banks, this language is often mentioned throughout the account agreement. Many banks exercise their right of set-off to deduct funds from an account holder’s deposit account when that account holder owes an outstanding amount because of fees, overdrafts, or unpaid monthly payments.
But remember: The right of set-off normally only goes into effect when the account holder uses the same institution for their checking and other banking needs.
Legal Basis for Set-Off Clauses
Common law rights apply to set-off clauses when two parties are reconciling debts between them. If party A owes $75 and party B owes $50, both debts can be finalized by party A paying party B $25.
This, in turn, leads into contractual agreements where one party is allowed to deduct money owed to them when those debts go unpaid. However, certain regulatory frameworks must be followed in order for the financial institution to remain compliant.
All financial institutions operating in the United States must adhere to regulatory laws. In general, if you have a complaint, you will want to contact the Consumer Financial Protection Bureau or your state banking regulator.
Implications for Borrowers and Account Holders
A set-off can have a big impact on your personal finances, especially if you’re unprepared for it. Because banks usually don’t have to notify account holders of set-offs, you may suddenly realize your account balances are lower than they should be. That can make you susceptible to overdrawing or not having enough funds to cover necessary expenses.
If you’re vulnerable to a bank invoking the set-off clause, you may want to take the appropriate steps to protect your finances.
Protecting Yourself from Set-Off Actions
To protect yourself from a bank or financial institution invoking the set-off clause, the first step is to understand it. If you’ve already signed an agreement with a set-off clause, you may want to reread through it. If it doesn’t make any sense to you, call the institution and ask to speak with an account specialist who can explain the clause and when it may be invoked.
If you haven’t signed any agreements yet, the terms may be negotiable. While set-off clauses are pretty standard, if your finances are strong, the bank may be willing to rewrite the terms to the contract so they are more favorable to you.
Another option may be to switch banks and close your bank account. As long as the new bank is not affiliated with the original lender, your money may be safe from the set-off clause. However, keep in mind that the lender may be able to take legal action against you. If they do, your assets may be put in jeopardy.
You may be wondering if closing a bank account impacts your credit score. As long as your account has a positive balance, closing it shouldn’t affect your credit score. If you have any automatic payments set up, just make sure you update those accounts so they stay current.
Recommended: How to Split a Joint Bank Account
Alternatives to Set-Off for Banks
When invoking the set-off clause isn’t an option, banks may take other measures, such as sending your debt to a debt collector, restructuring your loan so you can make your payments more easily, or even taking legal action. To avoid any negative consequences, you may want to consider taking out a personal loan for debt consolidation.
How debt consolidation works is simple: Apply for a personal loan and use that loan to pay off your debts at (ideally) a lower interest rate. You’ll likely save money in interest, and you may even have a lower monthly payment, too.
You can take out personal loans for credit card debt, student loans, car loans, or even other personal loans with higher interest rates. You can pay off multiple forms of debt with a personal loan.
Recommended: Beginner’s Guide to Good and Bad Debt
The Takeaway
A set-off clause is legal language that allows a lender to draw from a debtor’s deposit accounts in the event they default on a loan. But typically, it’s only implemented when the debtor uses the same financial institution for their loan as they do their checking and banking needs. To protect yourself against a set-off, read over your loan or account agreement and reach out to your financial institution with any questions. You may also choose to move your bank account to a new bank.
If you’re struggling to make payments, consider taking out a personal loan to pay down your debts. You could potentially get out of debt sooner, save money in interest, and may even save money with a lower monthly payment.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
FAQ
Can banks use set-off without notifying me?
The answer to this boils down to your loan agreement and local laws, but in most situations the bank does not have to notify the borrower when it invokes the set-off clause.
Does the set-off clause apply to joint accounts?
A set-off clause shouldn’t apply to joint accounts unless both people are on the loan and are both liable for payments.
Can I dispute a set-off action by my bank?
Yes, a set-off action can be disputed, but the bank may well be within its rights. To determine if the bank acted improperly, you’ll need to read through your loan agreement with the bank. If you’re positive the bank acted illegally, first contact the bank and begin a dialogue with them. If that doesn’t resolve the matter, you may need to file a complaint to the appropriate authorities and seek legal counsel.
How does the set-off clause affect my credit score?
A set-off clause being enacted should not impact your credit score. However, if you’ve been missing payments and are in default, then any late payments will have a negative impact on your credit score.
photocredit: iStock/shapecharge
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