A few months ago, a tornado damaged a customer’s home, which secures a mortgage loan. The resulting insurance check was made payable to our bank and the customer. We required the customer to deposit the check in a savings account naming our bank as custodian (as required by Freddie Mac’s servicing guidelines). Can we use the money in that account to offset a charged-off farm loan?

If the charged-off loan was made to your customer, then your bank may be able to exercise its setoff rights against the savings account. But first, we recommend reviewing Freddie Mac’s procedures for distributing insurance settlements. Freddie Mac’s procedures may require you to reserve the insurance funds for property repairs and related purposes.

Under Illinois law, the right of setoff can arise contractually (when the deposit account agreement provides for a right of setoff) or under the common law when there is “mutuality” of parties (the deposit account is owned by the same party that owes the debt to the bank). We recommend reviewing your savings account agreement to see if you are authorized to set off the savings account against monies owed to the bank. Having said that, even if your savings account agreement is silent on this issue, we believe you can exercise your common law right of setoff if the borrower is the sole owner on the savings account, given that the loan is in default.

However, Freddie Mac’s requirements for distributing insurance loss settlements may prevent you from using insurance proceeds to pay off an unrelated loan. You should carefully review the Freddie Mac Security Interest form used for the mortgage. In some cases, the Security Interest form may permit you to unilaterally apply insurance proceeds to the mortgage’s unpaid balance — but we do not know whether this right would extend to other, unrelated loans. Additionally, if your institution has submitted a repair plan for the mortgaged property to Freddie Mac, the plan may prevent you from using the insurance proceeds for purposes other than repairs.

For resources related to our guidance, please see:

Pope v. First of Am., N.A., 699 N.E.2d 178, 180 (3rd Dist. 1998) (This court held that a bank could exercise its contractual right of setoff for customer’s unauthorized withdrawals from another customer’s bank account.)
Selby v. DuQuoin State Bank, 223 Ill.App.3d 105, 107 (5th Dist. 1991) (The common law right of setoff requires a mutuality of parties, meaning that the deposit account is owned by the same party that owes the debt, as well as a matured debt.)
Freddie Mac Single-Family Seller/Servicer Guide, Section 8202.11, Insurance loss settlements (“The Servicer must take appropriate action to: — Verify the extent of the loss or damage — Ensure judicious disbursement of insurance proceeds for the necessary repairs, — Protect the priority of the Mortgage by obtaining, where necessary, waivers of materialman’s or mechanic’s liens, [and] — Document completion of the repairs.)
Freddie Mac Single-Family Seller/Servicer Guide, Section 8202.11, Insurance loss settlements (“The Servicer may be named as loss payee on insurance drafts and must comply with any applicable law and, where applicable, any requirement of the FHA, VA, RHS or MI. Details concerning the loss or damage and disposition of the insurance proceeds must be recorded in the Mortgage file.)
Freddie Mac Single-Family Seller/Servicer Guide, Section 8202.11, Insurance loss settlements (“Additional loss draft distributions: Remaining funds may be distributed based on the repair plan reviewed and approved by the Servicer with inspections prior to additional funds being released.”)
Freddie Mac Single-Family Seller/Servicer Guide, Section 8202.11, Insurance loss settlements (“A Servicer may unilaterally apply the insurance proceeds to the Mortgage's unpaid balance only to the extent allowed by applicable law and the Security Instrument. The Borrower, however, may unilaterally decide to have the proceeds applied to the Mortgage's unpaid balance.”)