What is a Letter of Credit?

A letter of credit is a document from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the total amount due. It is a very important aspect of international trade. It is used to signify that payment will be made to the seller on time and in full as guaranteed by a bank.

The bank will charge a percentage of the letter of credit as fee in addition to requiring a collateral from the buyer. Some of the most popular forms of letter of credit includes a revolving letter of credit, commercial letter of credit, and confirmed letter of credit.

Letters of credit are important in international trade transactions due to the distance involved, different trade laws in the countries of the businesses involved, and hurdles of in person meetings.

A letter of credit acts as a promissory note from a financial institution and guarantees a buyer's payment to a seller. The buyer applies for a letter of credit at a bank where it has funds deposited or a line of credit. 

The bank issuing the letter of credit will hold the payment on behalf of the buyer. When the bank receives confirmation that the goods in the transaction have been shipped, the seller will receive the payments due.

The terms of the sales contract have to be met including timed delivery or confirmation from the buyer that the goods have been received in good condition.

It also offers protection to the buyer and is similar in concept to an escrow service. Banks only release funds after certain conditions of the transaction are met.

Letters of credit are common in international trade, but can also be used in construction projects. It is simply a financial contract between a bank, the bank’s customer (importer), and a beneficiary (exporter).  

How letter of credit financing works

A letter of credit outlines the conditions under which payment will be made to a seller. When a buyer needs supplies for a product overseas, it contacts the product supplier.

The supplier will ask for assurance that the buyer will make payments before shipping the products. The buyer will then submit a purchase order to the bank.

The bank will then review the purchase order for authenticity and value. The bank will also verify the reliability of the supplier, financial status, assets, and credit worthiness of the buyer.

The issuing bank will act on behalf of the buyer to ensure that all conditions have been met before the funds of the letter of credit are released to the seller.

A lender will then issue a letter of credit which guarantees the buyer’s payment to the supplier. The supplier will shipped the products to the buyer. 

The buyer then issues the supplier an invoice with a copy sent to the supplier’s bank.
The invoice collateralizes the loan until it is paid by the buyer. 

Upon receipt of payment, the buyer’s bank will covers its costs and fees and remits the balance to the supplier’s bank to complete the transaction.

A letter of credit is a negotiable instrument. The issuing bank pays the beneficiary or any bank nominated by the beneficiary.

If a letter of credit is transferable, the beneficiary may assign a corporate parent or a third party the right to draw. 

Banks require a pledge of securities or cash as collateral for issuing a letter of credit. Commercial letters of credit are when the bank makes payment directly to the beneficiary. 

Revolving letters of credit can be used for multiple payments within a specific time frame. They are used for businesses that have an ongoing relationship. 


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Types of Letters of Credit


Commercial Letter of Credit

This is a direct payment in which the issuing bank makes the payments directly to the seller.

Revolving Letter of Credit

This allows a buyer to make any number of draws within a certain limit during a specific time period.

Traveler's Letter of Credit

This letter will guarantee that issuing banks will honor drafts made at certain foreign banks and is best for those travelling abroad.

Confirmed Letter of Credit

This involves a bank other than the issuing bank guaranteeing the letter of credit. 

The seller’s bank is the confirming bank and ensures payment under the letter of credit.

If the buyer and the issuing bank default on their obligations, the confirming bank will ensure payment to the seller. 


Irrevocable letter of credit

An irrevocable letter of credit ensures the buyer is obligated to pay the seller.

Import letter of credit

An import letter of credit allows importers to make payments immediately to exporters by providing them with a short-term cash advance.

Export letter of credit

An export letter of credit lets the importer’s bank know it must pay the seller (exporter), provided all the conditions of the contract are met.

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What are letters of credit used for?

Letters of credit are used to lower risks in international trade transactions where the buyer and the seller may not know each other.

An importer using a letter of credit can ensure that they only pay for goods after the supplier has provided shipping evidence.

This ensures the buyer does not need to make any advance payments or deposits to the exporter. 

A letter of credit also gives instant credibility with an exporter by demonstrating the importer’s creditworthiness.

As an exporter, a letter of credit is insurance in case the buyer fails to pay for the goods shipped. The bank will cover the outstanding amount due from the importer.

The letter of credit also protects the seller against legal risks and they are ensured payment as long as delivery conditions have been met.

Exporters can use a letter of credit as collateral against working capital loans to help fill the order. Working with an overseas buyer or seller can be very risky.

A letter of credit spells out the details of the transaction so that both the importer and the exporter are on agreement. 

Instead of assuming that things will work a certain way, everyone agrees on how to move forward with the transaction. 


How to get a Letter of Credit

To apply for and get a letter of credit, contact your bank’s international trade department or commercial division. Not every bank issues a letter of credit.

You can then apply for a letter of credit from the bank. Details required for application process includes all the details of the deal such as; the goods or services being exchanged, the payment amount, the expected delivery date, and other details.

The bank will decide whether or not to issue you with a letter of credit. There is no set fee for letters of credit.

The bank will decide on costs and expect to be charged a percentage of the amount covered by the letter of credit. 

This amount is no more than a few percentage points depending on variables like your credit history. 


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