What Is the Right of Offset in Banking?
Understand the legal basis for a bank's right of offset, a process rooted in the mutual debt relationship between a bank and its customer.
The right of offset is a legal tool for financial institutions, allowing them to seize funds from a customer’s deposit account to cover a past-due debt owed to the institution. This action is authorized by clauses within the account and loan agreements signed by the customer. For instance, if a person has both a checking account and a delinquent auto loan with the same bank, the bank can use funds from the checking account to satisfy the missed loan payments. This process is also known as the right of setoff. The consequence for the account holder is that funds can be removed without advance notice, potentially causing checks or pre-authorized payments to be returned for non-sufficient funds (NSF) and incurring additional fees.
The Foundation of Offset Rights
The legal principle underpinning the right of offset is the concept of “mutuality of debt.” This principle applies when two parties each owe a debt to the other. In the banking context, a unique dual relationship exists: when a customer deposits money, the bank becomes a debtor to the customer, as it owes the customer those funds. Conversely, when that same customer takes out a loan, the customer becomes a debtor to the bank.
This mutual debtor-creditor relationship is a prerequisite for the right of offset to exist. The debts must be between the same two parties, acting in the same legal capacity. For example, a bank cannot offset a personal debt owed by an individual from an account belonging to that individual’s separate business entity, as the parties are not acting in the same capacity.
For a bank to act on its right of offset, the debt owed to it must be mature and payable. This means the loan or credit line is in default, such as when a borrower has missed payments on a personal loan, auto loan, or mortgage. The specific terms are outlined in the loan and deposit account agreements, which define the scope and conditions under which the bank can exercise this right.
Accounts Subject to Offset
A bank’s right of offset extends to various types of deposit accounts held by the debtor. Standard checking accounts and savings accounts are the most common targets for this action. Funds held in certificates of deposit (CDs) are also vulnerable to offset, allowing a bank to access these savings to cover a defaulted loan with the same institution. The key factor is that the deposit account and the delinquent debt are held at the same financial institution.
The application of offset rights to joint accounts can be complex. If a debt is owed by only one of the owners of a joint account, the entire account could be at risk. The specific account agreement signed when the account was opened is a determining factor. Many agreements contain clauses that permit the bank to seize funds from a joint account to satisfy a debt owed by any single owner of that account.
This means that a co-owner who is not responsible for the debt could have their funds taken to cover the obligations of the other account holder. For example, if one spouse has a defaulted personal loan with a bank where the couple holds a joint savings account, the bank may be able to withdraw funds from that joint account to pay down the loan. This potential exposure highlights the importance of understanding the specific terms of a joint account agreement.
Limitations and Protected Funds
Despite a bank’s right of offset, certain funds are legally protected from seizure. Federal laws shield specific government payments from being taken to pay debts. Protected funds include:
- Social Security
- Supplemental Security Income (SSI)
- Veterans’ benefits
- Federal retirement funds
If a bank mistakenly seizes these protected benefits, the account holder has the right to have the money returned. The protection is strongest when the benefits are directly deposited; if funds are deposited by paper check, the account holder may need to prove the money is exempt.
Another limitation on the right of offset is the “automatic stay” that takes effect when an individual files for bankruptcy. The automatic stay prohibits creditors, including banks, from exercising their right of offset against pre-petition debts without first getting permission from the bankruptcy court. While the right of offset is not extinguished by the bankruptcy filing, it is suspended until the creditor obtains relief from the stay from the court.
The Offset Process
The execution of a right of offset is a direct action taken by a financial institution. Unlike a garnishment, which requires a court order obtained by a third-party creditor, a bank’s right of offset is a self-help remedy. This means the bank does not need to obtain a court order or provide the debtor with advance notice before seizing the funds.
When a qualifying debt becomes delinquent, the bank can internally transfer funds from the debtor’s deposit account to pay the outstanding balance. The bank can take as much money as is available in the account, up to the full amount of the debt owed. If the account balance is insufficient to cover the entire debt, the bank may perform subsequent offsets as new funds, such as a paycheck, are deposited into the account until the debt is fully paid.
Following the seizure of funds, the financial institution is required to provide the customer with a notice. This post-offset notification will inform the account holder that the action has taken place. The notice details the date of the offset, the amount of money that was taken, and the specific debt that the funds were applied to.