What Is a Set-Off Clause?

A Set-Off Clause Explained in Less Than 4 Minutes

A borrower looks over her lending agreement.

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A set-off clause is a legal provision that allows a lender to seize your financial assets if you default on a loan. This clause is usually included in the lending agreement, particularly when there’s a chance an individual won’t repay the money they owe.

A set-off clause typically allows the lender to collect more than they would have been able to in bankruptcy proceedings. Understanding how a set-off clause works will help you make better borrowing decisions in the future.

Definition and Examples of Set-Off Clauses

A set-off clause is a provision that gives your lender permission to seize your deposits or other assets if you default on a loan. The exact structure of the clause can vary, but they are commonly used in unsecured loan arrangements.

Set-off clauses aren’t limited to consumer lending agreements. These clauses can also show up in business contracts.

The set-off clause is triggered when you default on the terms of the agreement. By using a set-off clause, the borrower and the lender agree on what will happen if the borrower fails to repay the loan.

However, lending clauses are not added to every agreement. It is usually added to a contract when the lender considers a borrower to be high-risk.

  • Alternate definition: A set-off clause is a legal provision in a contract that protects the lender
  • Alternate name: Bank set-off

For example, let’s say you apply for a loan from a local bank where you have a checking account. When you read over your loan contract before signing it, you notice a provision stating that the bank will seize funds from your checking account if you default; this is a set-off clause.

Banks cannot use set-offs to seize income that is exempt under state or federal law or income to pay missed credit card payments, unless you’ve authorized it.

How Does a Set-Off Clause Work?

A set-off clause states that if a borrower defaults on a loan, the lender has the right to seize on the specific assets outlined in the clause. This reduces the amount of risk a lender is taking on because it ensures they receive a portion of the money owed to them.

In order for a bank or lender to exercise the set-off clause, it must meet the following requirements:

  • The debt is currently due, and the borrower is considered to be in default.
  • The bank can transfer the funds directly from the borrower’s account.
  • The account the bank will seize the funds from is the same account the borrower would have used to pay the loan.

If the lender plans to access funds at other financial institutions, this needs to be outlined in the set-off clause. Even if the funds aren’t easily accessible to the bank, a set-off clause gives your bank the right to tap other accounts.

Contracts that have set-off clauses will include the clause in your loan agreement. Look for terms like “Rights of Set Off.”

Some states impose their own limitations on set-off clauses. For instance, California prohibits set-offs if the combined balance of your various accounts is less than $1,000.

Benefits of Set-Off Clauses

A set-off clause benefits the lender because if the borrower defaults on a loan, the lender is protected.

Another benefit is that the clause may allow the lender to collect more money than it would receive in bankruptcy proceedings. Via a set-off clause, lenders may be able to obtain payment that’s equal to the amount borrowers owe.

Key Takeaways

  • A set-off clause is a legal provision that protects the lender.
  • It states that if a borrower defaults on a loan, the lender has a legal right to seize their assets.
  • By using a set-off clause, the lender ensures they’ll redeem more money than what they would receive by going through bankruptcy proceedings.
  • Set-off clauses are often used in lending agreements for consumers and businesses.