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A letter of credit is a document that’s used between two businesses. It guarantees that the buyer of a product will deliver payment to the seller in return for goods and services received. Letters of credit are better assurance that payments will be made on time than contracts. They can be particularly useful for international transactions in which two business parties do not know each other well. Read on to learn more about what a letter of credit is, how it works, and when to use one.
Letter of Credit Defined
A letter of credit is a document that a buyer’s bank will issue to a seller to guarantee that seller will receive payment for their goods and services. It helps the buyer and seller feel more confident about a given business transaction. The bank that issues the letter of credit is usually the same bank where the buyer holds their business account.
How a Letter of Credit Works
If two businesses do not have a strong relationship with one another, a seller may ask a buyer to provide a letter of credit from their bank. The issuing bank serves as a stop gap for payment, guaranteeing that the seller will be paid. Buyer’s will typically deposit money to cover the sale in an account with the issuing bank ahead of time. That money may be frozen in the account to ensure it’s there when the sale goes through. Alternatively, the buyer may be able to use a line of credit with the bank to cover the sale.
Letter of Credit Example
The letter of credit specifies conditions of payment, including how much payment should be, timing of payment, and instructions for delivery. The following is a letter of credit example transaction:
The buyer and seller draw up a sales agreement, and the seller applies for a letter of credit.
The buyer’s bank writes a letter of credit and sends it to the seller’s bank for approval. Once approved, the seller's bank sends it to the seller.
The seller ships the goods the buyer ordered.
The seller sends documentation of the shipment to their own bank, which verifies the documents. If they are correct, the seller's bank submits the documents to the buyer’s bank.
The buyer’s bank sends payment to the seller’s bank, and the buyer can claim their goods.
Banks will usually charge a fee to issue a letter of credit equal to a percentage of the total amount of money they are guaranteeing. For example, a bank might charge 0.75% of the total amount they guarantee. Banks may charge more or less for different types of letters of credit.
Are There Different Types of Letters of Credit?
There are several types of letters of credit. The letter you choose will depend on your needs and the type of transaction being completed.
Commercial Letter of Credit
Commercial letters of credit are used in commercial transactions, frequently used in overseas trades. The buyer’s bank will pay the seller directly in these cases.
Standby Letter of Credit
A standby letter of credit is a backstop in which a buyer’s bank will pay the seller only if the seller can prove they never received payment from the buyer themselves.
Revolving Letter of Credit
A revolving letter of credit allows buyers to make a number of transactions within a guaranteed period, guaranteeing payment for each.
Traveler’s Letter of Credit
A traveler’s letter of credit is a document banks give to travelers in foreign countries. The person can use the document to get money from foreign banks in the local currency.Recommended: Guide to International Banking
Confirmed Letter of Credit
A confirmed letter of credit usually comes from the seller’s bank. It guarantees that the seller will still get paid even if the buyer and the buyer’s bank default.
What Are the Advantages of a Letter of Credit?
The advantages to using a letter of credit include:
Reduces Risk
A letter of credit makes it highly likely that a seller will be paid for their goods and services because payment is guaranteed by the issuing bank. Risk reduction helps businesses to forge new relationships with each other by helping reduce an important barrier to entry to doing business together.
Outline Terms of the Deal
The letter of credit outlines in detail the goods the buyer is purchasing and the terms of payment for the seller, including amount, time, and delivery method.
Provide Security for Buyer and Seller
Payment is made securely between the buyer’s and the seller’s banks. Neither party has to worry about making the transaction themselves. Sellers may borrow against the guarantee of payment to provide the capital they need to fulfill the borrower’s order.
What Are the Disadvantages of a Letter of Credit?
Despite the benefits listed above, there are drawbacks to consider before applying for a letter of credit.
It takes time for banks to prepare letters of credit, which could add days to the total transaction time.
Banks May Require Collateral
Banks may require buyers to put up collateral to guarantee the sale. This may be money held in an account with the bank or other items of value.
When You should Use a Letter of Credit
You may want to use a letter of credit when entering into a new business relationship, especially one overseas. A letter of credit provides security to both the buyer and seller, which is helpful when conducting new business or business from afar.
The Takeaway
A letter of credit can be a useful tool for importers and exporters to minimize their credit risk and build trust. At the same time, it’s important to weigh the potential disadvantages, including increased costs, against these benefits. To carry out a transaction using a letter of credit, buyers and sellers will each need a relationship with a bank. The buyer will need an account where money can be held to pay the seller, and the seller will need an account where money can be deposited when the transaction is complete. Lantern can help you compare interest rates, fees, and account minimums for high-interest savings accounts from top providers across the county.Explore high-interest savings accounts with Lantern by SoFi.
Frequently Asked Questions
How much does it cost to get a letter of credit?
What is the risk of a letter of credit?
Do letters of credit count as debt?
Photo credit: iStock/MangoStar_Studio
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About the Author
Austin Kilham
Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.
