What is a Letter of Credit?

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Definition:

A letter of credit is an official statement from a bank promising that the holder will receive a set sum of cash after meeting the conditions of the letter.

🤔 Understanding a letter of credit

In the world of business, trust is one of the most critical aspects of conducting any transaction. A letter of credit adds confidence to a purchase or sale by ensuring the seller receives payment from the buyer. When a seller asks for a letter of credit, the buyer gives their bank the details of the planned transaction. The bank then sends a letter of credit to the selling company's bank. Once the businesses complete the sale, the buyer's bank sends funds to the seller's bank.

Example

Two hypothetical companies, Alpha and Beta, want to work together, with Beta purchasing potatoes from Alpha. Alpha wants to make sure that Beta has the funds to pay for the potatoes and asks Beta to get a letter of credit to use during the transaction.

Beta contacts its bank and requests a letter of credit for the amount that it plans to pay for the potatoes. Beta also tells the bank the details of the transaction, such as the number of vegetables involved and the expected delivery date.

Once Alpha reviews and approves the letter, the two firms complete the transaction. Once the letter's requirements are met (ie, the potatoes are delivered), Beta’s bank sends funds to Alpha’s bank.

Takeaway

A letter of credit is like getting a trusted member of the community to vouch for you…

If you're buying something from someone you've never met, they might want some additional insurance that you'll pay what you owe. Asking a trusted member of your community (like the town mayor) to vouch for you might give the seller that confidence. If, for some reason, you don't pay the seller, the person who vouched for you might decide to pay the seller to keep their good reputation.

With a letter of credit, the bank acts as a trusted community member and promises to pay the seller if they meet transaction requirements.

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What is a letter of credit?

A letter of credit (LoC) is a document issued by a bank. The bank issuing the LoC promises to provide payment to the holder of the letter once it meets specific requirements. That means that the bank takes on responsibility for payment, adding more trust to the transaction.

Typically, businesses use letters of credit when conducting transactions with other companies and want additional security. If one company sells a product directly to another, it doesn't have a guarantee that the other party pays for the thing it purchases. Similarly, if the buyer pays before receiving the product, there's no guarantee that the seller will ship the goods.

Letters of credit reduce both parties' risk. When a bank issues an LoC, it takes responsibility for issuing payment once both parties meet the precise terms laid out in the letter. The seller knows it won't pay until the buyer meets their conditions. Similarly, the buyer knows it will get paid if it fulfills its end of the deal.

What is an example of a letter of credit?

A letter of credit needs to contain very specific information about the transaction. Some examples of these requirements include:

  • Buying company
  • Selling company
  • Amount required in the LoC
  • Date of the purchase agreement
  • Effective date and expiration date of the LoC
  • When the selling company should receive the funds
  • Any requirements the seller must meet to receive funds
  • Any conditions or standards of practice that should apply to the LoC
  • How either party will notify the issuing bank of changes to the deal

How does a letter of credit work?

A letter of credit works by adding an intermediary to a financial transaction. If a buyer and seller want extra insurance for a sale, they can use a letter of credit. When a buyer asks their bank to issue a letter of credit, the bank takes on legal responsibility to pay the agreed amount. The seller feels confident about getting paid, while the buyer knows that the bank won't send payment if the seller doesn't complete its side of the sales.

The LoC includes a precise statement of the transaction that will occur and the requirements that each side must meet to complete the transaction. If the seller satisfies its requirements, the bank must send payment. It’s clear to the seller what it must do to get paid.

Letters of credit rely on the reputation of the issuing bank as well as international and national law. When a buyer and seller operate in different countries, it can be hard for either to bring the other to court if one side fails to complete the transaction. Determining the appropriate jurisdiction and potentially dealing with a legal case in another nation can be complicated.

Adding an LoC to the mix makes it easier for both parties because LoCs are governed by international regulations. The Uniform Customs & Practice for Documentary Credits adopted by the International Chamber of Commerce governs letters of credit and the institutions that issue them for international trade.

What is the letter of credit process?

The letter of credit process is not the first step in conducting a business transaction. Before either company starts the process, they must agree upon the terms of the sale. There's no point in getting a letter of credit until both sides agree to a transaction.

Once both companies decide to do business together, the buyer applies for an LoC through a bank. They can work with their regular bank or go to a different one that the seller is comfortable working with, such as a large, multinational bank for international transactions. The application includes precise details about the transaction, including the products involved, the amount to pay, and the requirements each side must meet to complete the sale. The bank reviews the buyer's application and decides whether to issue the letter.

If the buyer's bank approves the LoC, it sends a copy of the letter to the seller's bank. The bank reviews it and submits it to the selling business. If the seller reviews and approves of the letter, the transaction can move forward. The selling company ships to the buyer and provides documentation of the shipment to their bank.

The buyer's bank reviews the documents and sends them to the selling company's bank. That bank removes funds from the seller’s account and sends the payment to the buyer’s bank. The buyer then receives the funds as a deposit to its account.

Is a letter of credit a loan?

Not all letters of credit are loans, even though it sounds very similar to a line of credit. Sometimes, banks can offer LoC lines of credit that combine the two. A line of credit or a loan is money that a person or business can borrow from a bank or other lender. A letter of credit is a document that shows the issuing bank's promise to pay the seller the amount due.

Businesses use letters of credit and loans for very different purposes. They use letters of credit to help facilitate transactions, especially when working with a company based in another country. The letter of credit adds trust to the sale and helps both sides feel secure in moving forward.

Unlike letters of credit, companies use loans to make purchases, even if they don't have the cash to afford them. They can use loans to expand their operations, buy raw materials, or for almost any other purpose. That makes loans more multi-purpose, but they don't help a company build trust when transacting with another firm.

The other difference between the two is their cost. Typically, banks charge interest on loans, as well as origination fees and other charges. By contrast, you don't have to pay interest when you get an LoC. Instead, the bank charges a fee for the service.

How much does a letter of credit cost?

When a bank issues a letter of credit for a buyer, it takes responsibility for sending payment to a selling company. It won't take that responsibility for free, so it makes the buyer pay a fee for the service.

Usually, the buyer is charged a percentage of the payment amount. Typically, buyers pay 0.75%, but the fee can be higher in less developed countries. Sellers also have to pay fees, such as courier fees, postage, and authentication, which can range from $25 to $175 each.

Selling firms also have to pay some fees related to the letter of credit, such as postage and authentication fees.

What are the documents required for a letter of credit?

To apply for a letter of credit, the buyer needs a copy of the sales agreement it made with the seller. The agreement can take the form of a contract, purchase order, or other written documentation.

The agreement should include the amount and type of products involved, as well as the total cost the buyer must pay. It also has to specify the terms that the seller needs to meet to fulfill the transaction and receive payment.

When the applicant applies for the LoC, they also need to fill out any paperwork the bank requires.

What are the types of letters of credit?

Businesses use letters of credit in a variety of situations, so there are many different types depending on the specifics.

Commercial

A commercial letter of credit is the standard version that businesses use to conduct transactions. They don't have any special features or requirements.

Standby

A standby letter of credit serves as a promise from the issuing bank that it will submit payment if the buyer isn't able to. Standby LoCs show that the bank believes in the buyer and trusts them to submit payment.

Confirmed

When a buyer applies for an LoC, their bank issues and sends it to the seller's bank. The seller's bank reviews the letter and makes sure that it's valid. It then becomes a confirmed letter of credit.

The receiving bank then adds its own guarantee to the transaction, giving both parties an extra sense of security — and the LoC more weight.

Unconfirmed

An unconfirmed letter of credit is an LoC that hasn't been received, reviewed, and approved by the seller's financial institution. The only bank that guarantees an unconfirmed LoC is the issuing bank, which makes it less secure than a confirmed LoC.

Revolving

Businesses that apply for a revolving letter of credit can renew the letter for future transactions with fewer paperwork requirements than obtaining a new LoC. Companies frequently use them for regular, recurring transactions.

Back-to-Back

A back-to-back letter of credit is one that the seller can transfer to another party.

For example, a grocer in the United States wants to purchase bananas from a foreign exporter. It gets a letter of credit from its bank and sends that LoC to the seller's bank. The seller ships the bananas to the grocer to complete the transaction.

Before the grocer's bank releases payment, the banana exporter needs to pay its supplier of agricultural supplies. It transfers the grocer's letter of credit to its supplier, and the supplier receives payment from the grocer's bank. This satisfies both the grocer's and the banana seller's obligations.

Sight

A sight letter of credit is one that becomes payable immediately after the receiving bank reviews and confirms the document. Instead of waiting on confirmation that the seller completed the transaction, the issuing bank pays the receiving bank as soon as it is ready for payment.

Deferred

A deferred letter of credit gives the buying firm extra time to pay the seller compared to a typical LoC. With a standard letter, the buyer must release the payment as soon as the seller fulfills the transaction’s requirements, typically shipping the product.

With a deferred letter of credit, the buyer doesn't send payment to the seller until a period of time since the seller shipped the goods. This gives the buyer time to use the products it purchased and raise funds to pay the bill.

Red Clause

A red clause LoC lets the selling company receive some or all of the payment for a transaction before it ships the goods. This can be important for sellers that are low on funds or that need extra liquidity to handle immediate obligations.

Irrevocable

With a standard letter of credit, either the buying company or its bank can cancel the LoC at any time, possibly without warning. This provides less security to the selling business.

Neither the buyer nor the buyer's bank can cancel irrevocable letters of credit. Once the issuing bank sends the letter to the seller's bank, the only way to cancel the LoC is with the agreement of the buyer, seller, and the involved banks.

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