Letter of Credit: What It Is

A letter of credit is essentially a financial contract between the bank, the bank’s customers, and the beneficiaries. Typically, a letter of credit issued by the importer’s bank guarantees that money will be paid to the beneficiary if the terms of the letter of credit are met.

What is a Letter of Credit?

A letter of credit or letter of credit is a letter from a bank that guarantees that the buyer will receive the correct amount paid to the seller on time. If the buyer is unable to pay the purchase price, the bank pays all or the remainder of the purchase amount. He may be provided with an amenity.

Because of the nature of international transactions, such as distance, the different laws of each country, and the difficulty of knowing each party personally, the use of letters of credit has become a very important aspect of international trade.

What is it used for?

Letters of credit are used to minimize risk in international trade transactions where buyers and sellers may not know each other.

If you are an importer, you can use a letter of credit to ensure that the company will pay for the goods only after the supplier provides proof that the goods have been shipped. In addition, cash flow can be saved because there is no need to make a prepayment or deposit to the exporter. Finally, a letter of credit gives instant credibility to the exporter by proving your creditworthiness.

If you are the exporter, the letter of credit is insurance in case the buyer fails to pay for the goods you send. In this case, the outstanding amount will be covered by the financial institution. In addition, the letter of credit protects you from legal risks because payment is guaranteed as long as delivery conditions are met.

For exporters, a letter of credit can also be provided as collateral for a working capital loan to help fulfill your order.

How does a letter of credit work?

Buyers making large purchases may need a letter of credit to assure the seller that payment will be made. The bank issues a letter of credit to guarantee payment to the seller and is responsible for payment to the seller by default. Before the bank guarantees payment to the seller, the buyer must prove that the bank has sufficient assets or a sufficient credit limit for payment.

Since the letter of credit is usually a negotiable instrument, the issuing bank pays the payee or any bank designated by the payee. If the letter of credit is transferable, the beneficiary may transfer the rights of issue to another company, such as a corporate management company or a third party.

The International Chamber of Commerce’s Uniform Tariffs and Practices control letters of credit used in international transactions.

How does a letter of credit work?

It is important to understand how letters of credit work. By design, a letter of credit begins when both parties have a need for a transaction. One party will ask the addressee for a letter of credit.

Since a letter of credit is a document obtained from a bank or other financial institution, the applicant must work with the lender to secure the letter of credit. The process is similar to applying for a loan, in which the applicant completes and submits an application (usually, depending on the issuing bank, it includes a copy of a sales contract, purchase order or export agreement and several other documents). And then, again, as with a loan, the applicant waits for approval.

To get a letter of credit, applicants often have to work with a specific bank branch, such as the Department of International Trade or the Department of Commerce. As a business applying for a letter of credit, the applicant will pay a letter of credit fee (usually a percentage of the amount of the letter of credit).

Companies that successfully obtain a letter of credit confirm that the financial institution agrees to guarantee the amount of the transaction. This establishes confidence in the transaction, as the buyer is guaranteed to receive the full amount of the transaction. Letters of credit can be transferred depending on the bank or financial institution that purchased the letter of credit.

Again, it is usually used in international trade (especially imports and exports), but companies can also obtain letters of credit for domestic transactions.

Type of Letter of Credit.

There are several types of letters of credit that have their own advantages and considerations. Some are more common than others, and some types of letters of credit are useful for unique scenarios.

• Commercial letters of credit include: Commercial transactions, often involving international trade transactions. In this case, the bank pays directly to the beneficiary.
• Standby Letter of Credit: A secondary method of payment that pays the beneficiary if the bank can prove it has not received a promise from the seller.
• Revolving Letter of Credit: Used for a series of payments when two parties are expected to make several transactions together.
• Road Letter of Credit. The issuing bank guarantees compliance with other credit notes signed by certain foreign banks.
• Confirmed Letter of Credit: Typically, if both the buyer and the issuing bank default, the seller’s bank guarantees that the seller will make the payment.

By understanding the different types of letters of credit and how they work, you can better understand whether requesting or receiving a letter of credit can benefit your business in the future.