Your financial institution can take your money on deposit because of its right of setoff.
WHAT IS A SETOFF?
When you think of money being grabbed out of somebody’s checking or savings account, what probably first comes to mind is garnishment. That what happens when a creditor sues and gets a judgment against a person who owes it a debt, and the creditor then tries to collect on that judgment by garnishing the person’s bank accounts—getting the court to order that person’s bank to pay the money from that person’s account(s) to the creditor. With virtually all garnishments there is no relationship between the creditor with the judgment and the bank (or other financial institution) where the account is being garnished. The creditor is just trying to find the debtor’s money to collect wherever it can.
In contrast, a setoff is money being grabbed from a person’s account specifically by his or her own bank or financial other institution in payment of a debt that the person owesthat financial institution.
The idea behind setoff is if two people owe each other money, one person should be able to set off the amount it is owed against the amount it owes the other person.
Consider the simple example of two housemates, Marie and Julie, who agree to split expenses. So when Marie buys $150 of groceries for them to share, Julie owes her $75. But when Julie lends Marie $50 for a few days so she can have some personal spending money and then Marie doesn’t pay it back when she said she would, Julie can set off the $50 Marie owes her against the $75 debt Julie owes for the groceries, reducing Julie’s debt to $25.
BUT MY BANK DOESN’T OWE ME ANY MONEY SO HOW CAN IT DO A SETOFF?
If you have a savings or checking account, then the financial institution where you have that account owes you the balance on that account. A checking or savings account in fact is a debt owed by the financial institution to you. You don’t have a chunk of money with your name written on it sitting in their vault. The money on deposit is not your money, but rather belongs to the financial institution, which has given you a commitment that it will give you access to the money that is “in your account” based on the terms of your agreement with it. It has promised to pay you the money it owes you.
So if you fall behind in payments on a loan you owe to the financial institution where you have a checking or savings account, it can set off the amount it owes you—the money in your account—against the amount you owe on the loan.
To illustrate with an example, Henry has his vehicle loan at a bank and has fallen two months past due on its $350 monthly payment. He also has his checking account at the same bank, with a balance of $700 in it. The bank set off its $700 debt to Henry–the balance in the checking account—against the $700 he owes to it on the vehicle loan. In practical terms, the setoff reduces Henry’s checking account balance to $0, and also brings his vehicle loan current.
WHAT PROBLEMS ARE CAUSED BY BANK/CREDIT UNION SETOFFS?
A conventional garnishment requires the creditor to first sue you, serve you with the formal complaint, and get a judgment—either by “default” if you don’t respond by the stated deadline or by winning the lawsuit—and only then does it have the ability to garnish your bank accounts. In contrast, a setoff usually requires no prior notice to you. In some situations the creditor must give you notice that you are in default on the debt at issue. But setoffs happen with little or no warning.
Because a financial institution usually does not have to tell you that it is about to make you pay a debt you owe by taking money out of your checking and/or savings accounts for that payment, all kinds of problems—immediate and longer term—can occur.
The most obvious ones happen when a checking account is reduced to a $0 balance. When checks you have outstanding or debits that you have previously scheduled post to your account, there are no funds to pay them. They are returned unpaid, resulting in NSF (nonsufficient funds) fees being charged against your checking account. In addition, many of your now-unpaid payees would likely add their own NSF fees to the amount you owe them for their own extra administrative hassles. The fees on the checking account can rack up extremely fast, leaving you will a hefty negative balance, often before you even realize what is going on.
Your financial institution will then add insult to injury by threatening to close the checking account if you don’t quickly put enough money into the account to pay off the NSF fees and any other charges in order to bring the account to a positive balance. On top of that some of the payees on the outstanding checks will attempt to cash or deposited their checks a second time, potentially adding even more NSF fees if they don’t clear.
Coming up with the money to clear your checking account can be extremely challenging. You’re really strapped for money because you have to pay and clear the payees on the checks and debits that didn’t clear. Whether those checks/debits went to your local grocery store, a support payment for your ex-spouse, or for your car payment or car insurance, you will likely suffer both embarrassment and other more concrete bad consequences. Regardless, you will likely be under great pressure to make those checks/debits good, making it hard to pay on the checking account itself.
RUNNING AFOUL OF TELECHECK AND CHEXSYSTEMS
As you probably know, the consequence of writing NSF checks, especially ones that aren’t taken care of immediately, is that you will either not be able to use checks anymore, or only in a much more limited and highly inconvenient way. See our recent article about TeleCheck and the reports it and other similar companies generate on your check-writing history.
As may not be as well-known, other specialty consumer reporting companies, such as ChexSystems, focus on providing financial institutions with information on people who have had checking/savings accounts closed for negative balances and other adverse behavior. So if you can’t bring your checking account current in time to avoid it from being closed, you may well have trouble opening another checking or savings account at most other financial institutions.
ARE THERE LIMITS TO BANK/CREDIT UNION SETOFFS?
Yes, there are some modest limits.
In California, some state-chartered financial institutions may not do setoffs if you have less than $1,000 on deposit at that institution.
Under federal law and regulation, financial institutions cannot do a setoff of money in your account to cover missed consumer credit card payments that you owe the institution (unless you previously authorized it to pay your credit card through automatic withdrawals from your account).
Also, a corporate account cannot be set off for debts owed personally by a corporate officer. Similarly, funds in a trustee account cannot be set off for debts owed by the trustee personally.
HOW CAN I PREVENT SETOFFS?
Because the setoff right is so strong, you want to avoid situations where you could be the victim of a setoff.
So avoid, as much as possible, having your primary checking and saving accounts at the same financial institution where you owe a debt. The financial institution may require you to have an account there, but just keep the balance low and have your primary accounts elsewhere, where you have no debts.
WILL BANKRUPTCY UNDO A SETOFF?
In general, bankruptcy law respects creditors’ offset rights.
So if you file a bankruptcy case immediately after your financial institution does an offset, most likely the offset will still go through. The Bankruptcy Code states that the bankruptcy filing “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor [that is, money in a checking/savings account] that arose before the commencement of the [bankruptcy] case . . . against a claim of such creditor against the debtor [that is, the debt owed to the creditor] that arose before the commencement of the case . . . .”
In other words, if you owe a debt to a financial institution when you have money in a checking/savings account, and it exercises its setoff rights by cleaning out the account(s), your bankruptcy filing immediately thereafter will not undo that setoff.
WILL BANKRUPTCY HELP IN ANY OTHER WAY?
Yes, bankruptcy can prevent you from getting into the setoff’s vicious cycle.
Earlier in this article I described the extreme pressure on you that a setoff of particularly a checking account can cause. Besides following the commonsensical suggestions above about not having your checking/savings accounts where you also owe a debt, if you are at all concerned about a setoff happening, seriously consider seeing a good debtor/creditor or bankruptcy attorney about your options. And do so earlier rather than later. I have seen countless situations in which clients could have saved many hundreds, and often thousands, of dollars and loads of aggravation by not waiting until after a setoff to learn about their options.