Right Of Set Off

Updated on April 12, 2024
Article byGayatri Ailani
Edited byGayatri Ailani
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Right Of Set Off?

The Right Of Set Off is the legal right that allows two parties owing money to each other to set off their debts rather by making repayments. In the process, after offsetting the required amount, there is a balance amount that is obtained, which one finally has pay to the other party. In the banking sector, however, it works to provide banks with a legal mechanism to reduce credit risk and ensure the recovery of debts owed to them by customers.

the right of setoff

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This provision allows a bank to offset a debt owed to it by a customer against a credit balance in the same customer’s account. This means that if a customer owes money to a bank and also has money deposited in their account with the same bank, the bank can use the deposited funds to pay off the debt owed by the customer. It is an important risk management tool that can help prevent default and reduce the likelihood of non-payment or bad debt.

Key Takeaways

  • The right of set-off is a legal principle that enables a creditor to deduct an outstanding debt owed to them by a debtor from the credit balance available for the debtor.
  • The right of appropriation applies only to specific debts owed by the debtor, while the right of set-off applies to any debt owed to the creditor by the debtor, regardless of the source of the debt.
  • The use of the right of set-off is a crucial risk management mechanism that can aid in averting defaults, minimizing the likelihood of non-payment, and mitigating the possibility of bad debts.

Right Of Set Off Explained

The right of set-off is a legal principle that allows a creditor including banks to use funds from a debtor’s account to pay off a debt the debtor owes. This can occur in several scenarios. This includes when a customer defaults on a loan or credit card payment or when the bank has a legal judgment against the customer.

In the United States, federal and state laws and court decisions govern the right of set off. Under federal law, the right of set-off is a common law right, especially concerning banks. This allows them to offset a debt owed by a customer against a credit balance in the same customer’s account without prior notice or consent. However, the right of set off is subject to certain restrictions and limitations under federal law. This may include the Bankruptcy Code and the Truth in Lending Act.

The bankruptcy code, for example, provides that certain types of bank set offs are prohibited during bankruptcy proceedings. Specifically, banks are not allowed to set off debts owed to them by a debtor against any funds that the debtor has on deposit with the bank, except to the extent that the setoff is permissible under state law.

Similarly, the Truth in Lending Act requires banks to provide customers with written notice before they exercise their right of set off. This notice must include a description of the right of set off, the circumstances under which the bank may exercise the right, and any fees or charges associated with it.

State laws also play an important role in regulating the right of set off. Many states have specific statutes or regulations that govern these set offs. These laws may vary in terms of the types of debts that can be offset, the procedures that must be followed, and the notice that must be given to debtors.


Let us look at a few examples to understand the concept better:

Example #1

Suppose a customer has a savings account with a balance of $10,000 at Bank A. He also has an outstanding loan of $5,000 with the same bank. The customer has missed several loan payments and has failed to respond to the bank’s attempts to collect the debt. Under the terms of the loan agreement, Bank A has the right of set off the debt owed by the customer against the funds in the savings account. Bank A exercises its right of set off and uses $5,000 from the customer’s savings account to pay off the outstanding loan. The customer now has a balance of $5,000 in their savings account. He no longer owes any debt to the bank.

Example #2

In this series on employment contracts, common pitfalls within standard clauses have been outlined. A well-drafted employment contract succinctly lays out the terms and conditions with clear protections for the employer. However, issues arise when employers use a uniform contract template without considering individual circumstances. This may include an employee’s modern award coverage.

Examining set-off clauses within employment contracts, they serve to allow payments exceeding the minimum rate of pay. This fulfills various obligations under modern awards or enterprise agreements. Employers often utilize set-off clauses to provide a fixed annual remuneration. It simplifies payment calculations by covering all obligations under an award or agreement.

Employers relying on set-off clauses must ensure the fixed annual remuneration exceeds the minimum rate of pay and additional obligations under the applicable modern award or enterprise agreement. Failure to do so could result in breaches of the Fair Work Act, the relevant agreement, and potential legal consequences.

Employers must include well-drafted and enforceable set-off clauses in employment contracts. They must do this if they are relying on fixed annual remuneration to satisfy all payment obligations.

Right Of Set Off vs Right Of Appropriation

The difference between the right of set-off and the right of appropriation is as follows:

  • The right of set-off is a legal principle that allows a party to offset a debt owed to them by another party against a debt owed by the creditor to the same debtor. On the other hand, the right of appropriation is a legal principle that allows a creditor to apply a payment made by the debtor to a specific debt or debt owed.
  • The right of set-off is typically exercised after the debts have arisen. However, the right of appropriation is exercised at the time of payment.
  • The right of set-off is generally available as a common law right. But the right of appropriation may be governed by specific statutory or contractual provisions. Additionally, the right of appropriation typically requires the debtor to specify which debt they are making a payment towards. But the right of set off does not require any such specification.

Frequently Asked Questions (FAQs)

In what contexts does the right of set off concept apply?

The right of set off is the concept that is used in different contexts, including banking sector, contractual settings, insolvency matters, and legal proceedings.

What is the bank’s right to lien and set off?

A bank’s right to lien and set off are two distinct legal principles. They allow the bank to recover debts owed to it by a customer.

A lien is a legal right that allows a bank to hold onto or retain possession of a customer’s property. This may be money or securities until a debt is paid. On the other hand, the right to set off allows a bank to deduct money from a customer’s account. This can be used to repay a debt owed to the bank.

What is right to set off in banking?

The right to set off provides banks with the legal backing to adjust or offset a customer’s borrowed amount against his/her credit amount.

This article has been a guide to what is the Right Of Set Off. Here, we explain its examples and compare it with the right of appropriation. You may also find some useful articles here –

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