Are you wondering how to use a letter of credit?
In this blog, we have covered all aspects of a letter of credit that any business owner should know about.
But first, a fun fact! 🧐
Letters of credit actually date back to the early 1600s, when the Dutch East India Company issued credit letters to merchants in Europe and Asia.
Since then, the letter of credit has evolved over time and been used as a reliable payment method in international trade.
Table of Contents
What is a Letter of Credit?
It is a document issued by a bank or financial institution that guarantees payment to a specific individual or company, provided certain conditions are met. The document is usually used in international trade to ensure that the buyer is able to pay the seller for goods or services they have received.
It is also known as a documentary credit.
How Does a Letter of Credit Work?
A letter of credit is a payment mechanism used in international trade transactions. It is a document issued by a bank on behalf of a buyer that guarantees to the seller that the buyer will pay for the goods or services on time and in the agreed-upon amount.
➡️The process starts when the buyer applies for it from their bank.
➡️The bank then reviews the creditworthiness of the buyer and, if approved, issues the letter of credit.
➡️It is then sent to the seller’s bank, which verifies the contents of the letter of credit and the buyer’s ability to pay.
➡️The seller then ships the goods or provides the services.
➡️Once the buyer’s bank receives proof that the goods or services have been shipped or provided, the buyer’s bank pays the seller’s bank the amount specified in the letter.
➡️The seller’s bank then forwards the money to the seller, minus any applicable fees. The buyer then pays their bank the amount due.
Importance of Letter of Credit
It is a document issued by a bank that guarantees payment to a seller in the event that a buyer fails to pay for goods or services.
➡️A letter of credit provides security to both parties in a transaction, as it ensures that payment will be made as long as the terms of the letter of credit are met.
➡️This reduces the risk of fraud or non-payment and encourages buyers and sellers to do business without fear of non-payment.
➡️It also establishes trust between the parties involved in the transaction, as they know that the bank will ensure that payment is made in the event of a dispute.
➡️The use of it can also reduce the time and cost associated with international transactions, as the document eliminates the need for third-party intermediaries.
What are the Types of Letters of Credit?
Let’s have a closer look at the types of letters of credit.
1. Revocable Letter of Credit
This can be amended or cancelled at any time by the issuing bank without informing the beneficiary.
2. Irrevocable Letter of Credit
This cannot be amended or cancelled without the agreement of all parties involved.
3. Standby Letter of Credit
This is a guarantee from a bank to a buyer that the seller will fulfil their obligations under a contract.
4. Confirmed Letter of Credit
This is a guarantee from two banks, one of which is usually the seller’s bank, that the seller will fulfil their obligations under a contract.
5. Transferable Letter of Credit
A transferable letter of credit allows the beneficiary to transfer all or part of the credit to a third party.
Letter of Credit terminology
- Issuing Bank: The bank that issues the letter of credit on behalf of the buyer, and is responsible for ensuring that the terms and conditions of the letter of credit are met.
- Applicant: The buyer who applies for the letter of credit and agrees to pay the amount specified in the letter of credit.
- Beneficiary: The seller or exporter who receives the payment from the issuing bank upon fulfilling the terms and conditions of the letter of credit.
- Confirmed Letter of Credit: A letter of credit that is guaranteed by a second bank, known as the confirming bank, in addition to the issuing bank. This provides an extra layer of security for the seller.
- Irrevocable Letter of Credit: A letter of credit that cannot be cancelled or modified without the consent of all parties involved.
- Standby Letter of Credit: A letter of credit that is used as a backup payment method, in case the buyer fails to fulfil their obligations under the contract.
- Uniform Customs and Practice for Documentary Credits (UCP): A set of international rules governing the use of letters of credit in international trade.
Example of a Letter of Credit
Let’s have a look at a letter of credit sample:
How to apply for a letter of credit
- Negotiate terms with the buyer: Before applying for a letter of credit, you need to negotiate the terms of the sale with the buyer, including the price, delivery date, and payment method.
- Choose a bank: Select a bank that can issue a letter of credit on your behalf. It’s best to choose a bank that has experience in international trade and has a network of correspondent banks in the buyer’s country.
- Provide required documents: Provide the bank with all the necessary documents, including the purchase order, commercial invoice, and shipping documents. The bank will review these documents to ensure they meet the requirements of the letter of credit.
- Apply for the letter of credit: Fill out the letter of credit application form provided by the bank, and ensure that all the information is accurate and complete. Include details such as the amount of the letter of credit, the beneficiary (seller), and the applicant (buyer).
- Pay the fees: The bank will charge a fee for issuing the letter of credit, which can be a percentage of the letter of credit amount. Make sure to pay the fee promptly to avoid any delays.
- Wait for the letter of credit to be issued: Once the bank approves the application and receives payment, they will issue the letter of credit. The letter of credit will be sent to the beneficiary (seller), who can then use it to ensure payment.
Advantages & Disadvantages of Letter of Credit
Let’s have a closer look at the pros and cons of a Letter Of Credit.
| Advantage | Disadvantage |
| It provides protection to both the buyer and the seller. The buyer is protected from non-delivery of goods, while the seller is protected from non-payment. | Obtaining this can be time-consuming and costly, as additional fees may be required. |
| It can help reduce the risk of doing business with unfamiliar buyers since all the payment and delivery terms are clearly defined and agreed to upfront. | The terms and conditions of it must be very specific and must be followed precisely in order for the buyer to receive payment from the issuing bank. |
| It is an accepted form of payment in international trade, allowing buyers and sellers from different countries to do business with each other. | If the buyer does not pay the issuing bank on time, the issuing bank may be forced to pay the seller, even if the buyer has not received the goods or services. |
| It can help to expedite transactions and make them more efficient. | The seller may be subject to significant financial risk if the terms of the letter of credit are not followed precisely. |
A letter of credit is an important tool for businesses to ensure safe transactions between parties. It is a guarantee from a bank that the buyer will pay the seller for the goods and services purchased. It is a secure way for businesses to trade as it offers protection for both parties involved in the transaction.
Despite its benefits, there are also some drawbacks to using a letter of credit. These include the cost of issuing the letter of credit, the time required to process the letter of credit, and the potential for fraud. Overall, a letter of credit is an important tool for businesses to use when trading and its benefits outweigh the drawbacks.
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Frequently Asked Questions
What is the difference between a commercial letter of credit and a revolving letter of credit?
A commercial letter of credit is a document issued by a bank that guarantees payment to a seller if the buyer fails to pay. It is a one-time transaction, and once the funds are paid out, the letter of credit is no longer valid. A revolving letter of credit is similar to a commercial letter of credit, but it is open-ended and can be used multiple times. It is typically used by businesses that need to make frequent payments and don't want to issue a new letter of credit each time.
How does a letter of credit help the buyer?
A letter of credit helps the purchaser by providing them with a guarantee that the seller will receive payment for the goods or services provided. The letter of credit guarantees that the payment will be made by the issuing bank to the seller, even if the buyer fails to make payment. This provides the buyer with assurance that the seller will receive payment, thereby reducing the risk of doing business with them.
How does a letter of credit help the sellers?
A letter of credit is a financial document that guarantees payment to the seller. It is a form of payment security that reduces the risk of non-payment by the buyer. The letter of credit eliminates the risk of non-payment by ensuring that the seller will receive payment in full as long as they meet all of the terms and conditions of the letter of credit. This gives the seller assurance that they will get paid and helps them to be more willing to sell their goods
What type of collateral is required to open a letter of credit?
Typically, a letter of credit requires some form of collateral, usually in the form of a cash deposit or other financial instrument. The amount of collateral required will depend on the amount of the letter of credit and the risk associated with the transaction.
When does a seller or a beneficiary receive the payment from the bank?
A seller or beneficiary typically receives payment from the bank within 1-2 business days after the funds have been received from the buyer's bank.
