Set-Off Clause: Definition, How It Works, Benefits, and Examples

What Is a Set-Off Clause?

A set-off clause is a legal clause that gives a lender the authority to seize a debtor's deposits when they default on a loan. A set-off clause can also refer to a settlement of mutual debt between a creditor and a debtor through offsetting transaction claims. This allows creditors to collect a greater amount than they usually could under bankruptcy proceedings.

How a Set-Off Clause Works

Set-off clauses give the lender the right of setoff—the legal right to seize funds from the debtor or a guarantor of the debt. They are part of many lending agreements, and can be structured in various ways. Lenders may elect to include a set-off clause in the agreement to ensure that, in the event of default, they will receive a greater percentage of the amount that's owed them than they might otherwise. If a debtor is unable to meet an obligation to the bank, the bank can seize the assets detailed in the clause.

Set-off clauses are most commonly used in loan agreements between lenders, such as banks, and their borrowers. They may also be used in other kinds of transactions where one party faces a risk of payment default, such as a contract between a manufacturer and a buyer of its goods. The Truth in Lending Act prohibits set-off clauses from applying to credit card transactions; this protects consumers who decline to pay for defective merchandise purchased with their cards, using what's known as a chargeback.

Examples of Set-Off Clauses

A lending set-off clause is often included in a loan agreement between a borrower and the bank where they hold other assets, such as money in a checking, savings, or money market account, or a certificate of deposit. The borrower agrees to make those assets available to the lender in the case of default. If assets are held at that lender, they can be more easily accessed by the lender to cover a defaulted payment. But a set-off clause may also include rights to assets held at other institutions. While those assets are not as readily accessible to the lender, the set-off clause does give the lender contractual consent to seize them if a borrower defaults.

A set-off clause might be also part of a supplier agreement between the supplier, such as a manufacturer, and a buyer, such as a retailer. This type of clause can be used in place of a letter of credit from a bank and gives the supplier access to deposit accounts or other assets held at the buyer's financial institution if the buyer fails to pay. With a set-off clause, the seller can obtain payment equivalent to the amount that's owed them under the supplier agreement.

Benefits of Set-Off Clauses

Set-off clauses are used for the benefit of the party at risk of a payment default. They give the creditor legal access to a debtor’s assets at either the lender's financial institution or another one where the debtor has accounts. Before signing a contract with a set-off clause, borrowers should be aware that it may result in the loss of assets they would have been able to retain through other means of debt settlement, such as bankruptcy.