Letter of Credit (LC)Explained and Why it is Important for your Business!
What is a Letter of Credit?
A letter of credit which is also sometimes called a credit letter is a document from a bank guaranteeing that a buyer will pay a seller the agreed-upon payment by the due date.
Additionally, the bank agrees that should the buyer not make the payment for the purchase, the bank will pay either the full amount due or any remaining payment due on the purchase.
These letters have become increasingly common because of the way international business deals work.
This includes the distance involved in these situations, having to deal with the different countries’ laws, and not knowing the other people involved in the deal.
Credit References
A credit letter is like a negotiable instrument.
If a bank issues a credit letter to a seller, it guarantees the funds for the payment are available.
Additionally, a credit letter can be transferred like a money order or check.
The person or entity it is transferred to can then draw the funds from the bank in the same way they would a check.
Most banks do require collateral in order to issue a letter of credit.
They also charge a fee for a credit letter.
The fee is generally a percentage of the amount of the credit letter.
Types of Credit Letters
There are various types of credit letters, and here is a description of some of them:
Confirmed Letter of Credit
If a credit letter is confirmed, it means another bank has guaranteed that the payment will be made.
It is possible that a seller may not trust the letter given by the buyer from the buyer’s bank if they know little about the bank.
When this happens, it is possible the seller may want a bank in their own country to confirm the credit letter.
Then, if the bank issuing the credit letter does not pay, and the seller fulfills the requirements as contained in the credit letter, the confirming bank will be required to pay the seller.
Unconfirmed Letter of Credit
An unconfirmed credit letter is guaranteed only by the bank that issued the letter. The letter has not been confirmed by a bank in the seller’s country.
Commercial Letter of Credit
A commercial letter of credit is a direct payment method in which the bank pays the beneficiary once the terms of the agreement have been fulfilled.
Restricted Credit Letter
With a restricted credit letter, the issuing bank restricts the negotiation of the document to a specific bank.
Unrestricted Credit Letter
An unrestricted letter of credit allows the beneficiary to negotiate the document at any bank.
Credit Letter Example
As an example of a credit letter, suppose Company Y in Vietnam sells a specialty bolt that Company X wishes to purchase for its manufacturing facility in Taiwan.
The bolts would cost $250,000. However, Company Y is not sure whether or not Company X will be able to pay for its purchase.
In order to assure Company Y that it will receive payment for the purchase, Company X obtains a letter of credit from its bank stating that Company X will pay Company Y $250,000 for its purchase within 30 days.
If Company X does not pay the $250,000 within 30 days, the bank will pay the $250,000.
Once the bolts are shipped, Company Y requests payment for the shipment from the bank.
The letter of credit ensures the seller will be paid.
However, it can also protect the buyer since the bank will require proof that the purchase was shipped before paying the seller.
Commercial Letter of Credit vs. Revolving Letter of Credit
Commercial letters of credit are a type of credit letter in which the bank pays the beneficiary directly once the terms of the agreement are met.
In contrast, a revolving letter of credit can be used by a company to make a number of payments as long as they are made within a certain time period.
This type of credit letter is generally used for businesses that have a long-term relationship with each other, and the letter is usually good for a year.
Key Takeaways
- A credit letter is a written document from a financial institution that guarantees that a certain payment will be made on time for a particular business transaction.
- Credit letters are common in the international trade industry.
- There are a number of different kinds of credit letters.
FundsNet requires Contributors, Writers and Authors to use Primary Sources to source and cite their work. These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Reputable Publishers are also sourced and cited where appropriate. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy.
Cornell Law School "letter of credit" Page 1 . July 25, 2022
Cornell Law School "§ 2-325. Letter of Credit Term; Confirmed Credit." Page 1 . July 25, 2022