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A letter of credit is a document from a bank or financial institution guaranteeing that a buyer’s payment to a seller will be made on time and for the correct amount. As part of a sales agreement, a seller may require the buyer to deliver a letter of credit before a deal takes place.

Letters of credit are often vital in international trade, where the two parties involved may not be familiar with one another. Letters of credit facilitate new trade and timely payments.

Read on to learn more, including:

•   What a letter of credit is

•   How a letter of credit works

•   What the different types of letters of credit are

•   The pros and cons of letters of credit

•   How to get a letter of credit

What Is a Letter of Credit in Banking?

A letter of credit in banking is a document that a bank issues to a seller that guarantees payment from the customer for an order or service. The bank where the buyer’s business account is held usually assumes responsibility for the payment for the goods. However, the conditions laid out in the letter of credit must be fulfilled. If the buyer is unable to fulfill the purchase, the bank must pay the seller the purchase amount. The bank or financial institution charges the buyer a fee for guaranteeing the payment and issuing the letter.

Letters of credit are common in international trade situations because various factors can affect cross-border transactions. For example, the deal might involve different legal frameworks, a lack of familiarity between the parties involved, and geographic distance.

If you’re a buyer who is planning to be involved in international trade, you’ll likely want to open a bank account that can provide you with a letter of credit when you need it.

How a Letter of Credit Works

When used properly, letters of credit can work to minimize credit risk and help facilitate international trade. A vendor selling products or services overseas may want assurance that a buyer will pay, perhaps because the buyer is new to them or is a new business.

So how does a letter of credit work? It serves as a guarantee from a bank that payment will be made to the vendor once the requirements are met. The letter lays out the conditions of payment, such as the amount, the timing of the payment, and the delivery specifications. The letter may also help the business placing the order build their credit.

The bank charges the buyer a fee for issuing a letter of credit (anywhere from 0.5%-3% of the amount of the deal). It also does the due diligence to verify the buyer’s creditworthiness and requires collateral or security from the buyer as a payment guarantee. In essence, the bank acts as a third party facilitating the deal.

Recommended: Why Is Having a Good Credit Score Important?

Types of Letters of Credit

Here are five types of letters of credit:

•   Commercial letter of credit: This is a method in which the issuing bank pays the seller directly. For a standby letter of credit, which is a secondary method of payment, the bank only pays the seller if the buyer cannot transfer funds.

•   Revolving letter of credit: With this type, the bank guarantees payment for a number of transactions, such as a series of merchandise shipments, within a set period of time.

•   Traveler’s letter of credit: With this kind of letter, travelers can make withdrawals in a foreign country because the issuing bank guarantees to honor those withdrawals.

•   Confirmed letter of credit: A seller using a confirmed letter of credit involves a secondary bank — typically the seller’s bank — to guarantee payment if the first bank fails to pay.

•   Irrevocable letter of credit: This is a letter of credit that can’t be changed or canceled unless all parties agree.

Letter of Credit Example

Here’s an example of a letter of credit: A bank provides commercial and standby letters of credit, with processing times varying depending on the institution and the transaction. The funds are secured through deposits at the bank, and the terms are renewable. These documents can help reassure parties doing business internationally, especially with new businesses or clients who have recently started a business.

The Money Behind a Letter of Credit

So where do the payment funds for a letter of credit originate? The party paying for the goods or services typically deposits funds in advance with the bank that issues the letter of credit to cover the payment. Alternatively, the amount might be frozen in the payer’s account, or the payer might borrow from the bank using a line of credit.

When Does Payment Happen?

Payment usually occurs when the seller has completed all the stipulations in the letter of credit. For example, the seller might have to deliver the goods to a specific address or onto a ship for transportation if it involves international trade. In the latter case, shipping documents would serve as proof that the requirements for payment have been fulfilled and would then trigger the payment transaction.

What to Watch Out For

Here are some common mistakes sellers may make when relying on a letter of credit for payment:

•   Failing to check all of the requirements in the letter of credit

•   Failing to understand the documents required for the deal

•   Failing to confirm whether the time limits for delivery and payment are reasonable

•   Failing to meet the time limits

•   Failing to get the necessary proof-of-delivery documents to the bank

Letters of Credit Terminology

Here are some terms and phrases to know if you’re looking to use a letter of credit:

•   Advising bank: This is the bank that informs the seller that the letter of credit has been completed. The advising bank is also called the notifying bank.

•   Applicant: This is the party or buyer of products or services who applies for the letter of credit from the bank

•   Beneficiary: This is the party or seller who will receive payment. The seller usually requests a letter of credit to guarantee payment.

•   Confirming bank: This is the bank that guarantees the payment of the required funds to the seller. If a third party is involved, the confirming bank is often the seller’s bank.

•   Freight forwarder: This is the shipping company that provides the transportation documents to the seller.

•   Intermediary: These are companies that link buyers and sellers and may use letters of credit to ensure transactions are executed.

•   Issuing bank: This is the bank that issues the letter of credit.

•   Negotiating bank: If a third party is involved, the negotiating bank works with the beneficiary and the other banks involved. They likely determine the letter of credit requirements and complete the transaction.

•   Shipper: This is the transportation company that ships goods.

•   Standby letter of credit: This is a secondary letter of credit that’s used when a deal requirement has not been met. For example, if payment does not occur within the specified timeframe, a standby letter of credit would then be used to help guarantee that the deal goes through.

Pros and Cons of Letters of Credit

A letter of credit provides security for both parties involved in a trade, but it can also add costs and time to business transactions.

How to Get a Letter of Credit

Getting a letter of credit usually requires a few steps. It’s wise to get the necessary paperwork together first. Various documents will usually be listed as requirements for a trade, such as a shipping bill, a commercial invoice, insurance documents, a certificate of origin, and a certificate of inspection.

Here are the steps typically taken to obtain a letter of credit:

1.   The buyer and seller come to an agreement on the sale terms and the use of a letter of credit.

2.   The buyer contacts their bank, where they have a checking account, and requests a letter of credit, providing the necessary documents.

3.   The issuing bank prepares the letter based on the terms of the sales agreement and sends it to the confirming bank or advising bank, which is typically in the seller’s home country.

4.   The confirming bank verifies the terms and forwards the letter to the seller.

5.   The goods can then be shipped, and the exporter sends documentation to the advising or confirming bank.

6.   Document verification and settlement of payment can then occur.

When to Use a Letter of Credit

A letter of credit is beneficial for sellers entering into a new or international trade relationship. It can provide assurance that the seller will receive payment, because the issuing bank guarantees payment once the requirements have been met. Sellers may also use the guarantee of payment to borrow capital to fulfill the buyer’s order.

The Takeaway

A letter of credit is usually requested by an exporter or seller to minimize credit risk. The buyer of the goods or services applies to a bank and requests a letter of credit based on the sales agreement. This document helps guarantee that payment will be made. It can provide reduced financial risk when conducting international trade or doing business with a new customer.

Another path to financial stability is choosing the right bank account. Whether you’re looking for a business account or a personal account, it’s wise to shop around to find the best banking fit for your needs.

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FAQ

How much does a letter of credit cost?

A typical fee for a letter of credit is 0.5% to 3% of the deal amount. However, the rate will vary depending on the country and other factors.

How do you apply for a letter of credit?

Once the terms of a trade are agreed upon between the buyer and the seller, the buyer contacts their bank to request a letter of credit. They then gather the required documentation and fill out an application with that bank.

Why do you need a letter of credit?

The parties involved in a trade typically use a letter of credit to minimize risk. For the seller, a letter of credit can guarantee payment for goods once certain requirements have been met, and it confirms the buyer’s creditworthiness as a trade partner.

What is the difference between a letter of credit and a line of credit?

A letter of credit guarantees payment to a seller once the agreed conditions are met, while a line of credit allows a borrower to access funds up to a set limit. A letter of credit is typically used in trade transactions, whereas a line of credit is used for ongoing borrowing needs.

Who pays for a letter of credit?

The buyer typically pays the fees associated with a letter of credit. These fees are charged by the issuing bank for guaranteeing payment and may vary depending on the transaction size and risk level.

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SOBNK-Q126-087

A banker’s acceptance (BA) is a financial instrument used to guarantee large future transactions, often in the import/export markets. As a debt instrument, it can function as an investment, commonly traded between large banks and institutional investors on the secondary market. It can trade at a discount to par, similar to U.S. Treasury bills in money markets.

BAs play a key role in facilitating international trade and in broader fixed-income markets. While you may not own an individual banker’s acceptance in your checking account, these instruments help promote sound and liquid markets.

What Is Banker’s Acceptance?

A banker’s acceptance (which you may see written as “bankers acceptance”) is a short-term form of payment guaranteed by a bank. It is often used for international trade transactions.

Banks often make money on the spread between the buy and sell price of a fixed-income asset or through fees and commissions. BAs commonly have a maturity between 30 to 180 days, though they are limited to 270 days in most cases, and they trade at a discount to par. Functioning like a post-dated check, they are seen as a relatively safe method of payment for large transactions. BAs are considered short-term debt instruments.

Here are some more details about banker’s acceptances and how these instruments work.

•   The BA is issued and priced based on the creditworthiness of the issuing bank. An investment banker earns a commission for making the transaction.

•   Only customers with a strong credit history can access the BA market. These customers are often corporations involved in international trading (import/export) markets.

•   A banker’s acceptance can also be highly marketable and liquid, allowing money to transfer from one bank to another.

How Banker’s Acceptance Works

A banker’s acceptance is considered a time draft. A business can request one from a bank as a way of gaining enhanced security while conducting a deal. The bank essentially promises to pay the firm that is exporting goods a particular amount of money on a certain date. When it does this, it takes funds out of the importer’s bank account.

The term of a banker’s acceptance is frequently within 30 to 180 days.

Who Issues Banker’s Acceptance?

Not all banks offer BAs. Businesses with a good relationship with a large bank can obtain a banker’s acceptance. It can be an appealing product for an institution entering a large-value transaction. Like signing a check over to someone, the account holder must have enough cash to execute the transaction.

More than a simple checking account transaction, though, obtaining a BA typically requires a certain amount of credit to be detailed. There are usually fees involved in obtaining a BA, too.

Who Buys Banker’s Acceptances?

Banker’s acceptances are traded by banks and securities dealers on a secondary market, similar to how debt instruments are traded. They’re available at a discount on their face value. The exact value may vary with the rating of the bank that has promised payment on the banker’s acceptance.

How Banker’s Acceptance Is Used

Here’s more detail on how banker’s acceptances can be used.

Checks

Think of a banker’s acceptance as a certified check. It’s a relatively safe way to do a transaction. The money owed is guaranteed on the specific date listed on the BA bill. Credit analysis is usually done to verify the creditworthiness of the issuer, so it’s a bit different than how a bank will verify a check before you deposit it.

BAs are frequently used to facilitate the international trading of goods. A buyer of imported products can issue a BA with a payment date after a shipment is scheduled to be delivered. The seller exporting the goods can then take payment before finalizing the shipment. The exporter in this case can hold the BA to maturity or sell it on the secondary market. Unlike a check, the BA is backed by the guarantee of the bank, not an individual.

Investments

Aside from the import/export market, bankers’ acceptances are commonly used in the investment world. Buyers might purchase a BA and hold it to maturity to effectively earn a rate of return on short-term money. Since BAs are seen as very low-risk products, they are used as a cash-like security.

Still, retail consumers usually won’t be able to purchase a BA in an online or traditional retail bank. The purchase is, as noted above, only available to certain financial entities.

Recommended: What Are Some Safe Types of Investments?

Pros and Cons of Banker’s Acceptances

There are a number of positive aspects of banker’s acceptances to consider.

Pros

First, the upsides of BAs:

Provides Seller Assurances Against Default

Backed by the guarantee of a bank, a banker’s acceptance is regarded as a high-quality fixed-income security that is often liquid and highly marketable. For importers and exporters, financial transactions can be made to facilitate international trading of goods without the risk of one party going bust.

Buyer Does Not Have to Prepay for Goods

A banker’s acceptance works like a promissory note, so the buyer does not have to prepay. Liability can immediately transfer from the issuer of the BA to the bank. The payment is likely debited only on the due date.

Enhances Confidence in the Deal

Part of the process of issuing a banker’s acceptance is usually having a good credit standing and a relationship with a major bank. Since high-risk customers might not be considered, there is strong confidence in the BAs traded. There’s no need for the exporting company to worry about default risk, since that lies with the banker. While individual investors often do not engage in BA trading, there are important traditional banking alternatives that feature financial solutions to help facilitate transactions.

Cons

While there are many positive aspects of banker’s acceptances, there are still some risks for those involved in their transaction and trading. Consider the following:

Bank May Require Buyer to Post Collateral to Hedge Risk

Collateral is sometimes required for a deal to happen. Collateral provides a backstop should the importer be unable to pay. It can reduce risks to the bank and expedite the deal. Think of it as seller concessions to get a deal done, though collateral is generally not used when buying and selling a home.

Buyer May Default

With a banker’s acceptance, the bank accepts default risk, which can be a downside. The issuing bank typically must honor the payment terms even if the account holder, perhaps an importing/exporting corporation, does not have the cash on the payment date. Not all banks choose to be in this market due to the risk that the buyer could default.

Potential Liquidity Risk

Liquidity risk means an individual or financial institution cannot meet its debt obligations in the short term. Investors may not encounter liquidity risk with a banker’s acceptance instrument, but the issuing bank could have liquidity risk from the importer who must pay. This may be a key consideration for a bank issuing a BA. The secondary market for BA products remains highly liquid.

The Takeaway

A banker’s acceptance is a debt instrument that plays a key role in well-functioning capital markets. BAs help facilitate international trade through bank guarantees. Knowing about this important fixed-income product type can help individuals understand financial markets and institutions.

When it’s time to take a look at your personal banking partner, it can pay to shop around for the right fit.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with eligible direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

FAQ

What is the difference between a letter of credit and a banker’s acceptance?

A letter of credit is a financial instrument that a bank issues for a buyer (the bank client), guaranteeing that a seller will be paid. A banker’s acceptance (BA), on the other hand, guarantees that the bank will pay for a future transaction, rather than the individual account holder.

What is a banker’s acceptance in a real-life example?

An example of a banker’s acceptance (BA) would be that, on April 1, the Acme Bank sends a BA to Back-to-School Supplies, saying it will make funds available on June 1 for a shipment of goods for their client. On June 1, the school supply company will be able to withdraw those funds.

How safe are banker’s acceptances?

Banker’s acceptances are a relatively safe instrument for all involved. The exact degree of risk will vary with the creditworthiness of the bank guaranteeing the funds.

Is a banker’s acceptance a short-term investment?

Banker’s acceptances are considered a short-term investment or debt instrument. They are usually traded at a discount and are seen as similar to Treasury bills.

Is a banker’s acceptance a loan?

A banker’s acceptance isn’t a loan. It’s a short-term debt instrument, typically with a maturity date of 30 to 180 days.

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SOBNK-Q126-099

A sweep account automatically transfers, or “sweeps,” money from one account into another, with the goal of earning a higher rate of return. This is usually done to prevent excess cash from sitting in a low-rate account, but sweep accounts can also be used to pay off loans.

Sweep accounts are set up to make these transfers automatically, usually at the close of each business day. If you have several different accounts with a particular bank or brokerage, you may be able to take advantage of a sweep account — and it may be worth considering.

What Is a Sweep Account?

A sweep account is typically used when you hold more than one account (e.g., personal checking and savings accounts or different brokerage or business accounts) at a single institution. To use a sweep account, you set a threshold, such as a certain balance in a checking account, and the sweep account will automatically move funds above that threshold into another account that earns a higher return (typically a money market mutual fund).

This helps to ensure that you don’t keep cash parked in low-interest accounts and that you’re maximizing the total return across all of your accounts.

Ways to Use a Sweep Account

As an example of how someone might use a sweep account, you may keep a predetermined amount in the checking account to pay your bills. Then, at the end of each business day, any excess money is swept into a savings account or money market fund that earns a higher interest rate.

A sweep account may also be used at a brokerage, where your contributions or deposits (as well as dividends or profits from selling securities) are transferred to an investment account like an IRA, which stands for individual retirement account, or a taxable account at regular intervals.

Benefits of a Sweep Account

Using a sweep account can offer a couple of benefits. It allows you to keep a set amount of money in your checking account, say, to make sure you have sufficient funds to pay your bills without overdrawing the account. It also allows you to take any funds above that amount and put them in an account with a higher return.

You can also set up a sweep account when you open a brokerage account. This can also be valuable because different investments may generate returns or dividends at different times, and the sweep account makes sure the money doesn’t sit in cash but gets reinvested and put to work.

How Do Sweep Accounts Work?

One of the golden rules of investing is to try to maximize your returns, subject to your risk tolerance. A sweep account can be a great tool to help you do that because it helps to overcome inertia, a common behavioral finance hurdle for investors.

Using a sweep account allows you to set an amount of money that you always want to keep in your main account. Then, at the close of each business day, any extra money is swept into a savings, money market fund, or brokerage account that may generate higher returns. Depending on where you want to sweep the funds, they can remain fairly liquid and accessible, or they can be part of a longer-term tax-efficient investing strategy.

You can also set up a sweep account to help pay off a loan or a line of credit — another potential use of your spare cash. Beware of fees, though. Some sweep accounts are complimentary, but some aren’t. You don’t want the cost of maintaining a sweep account to eat up the extra interest or returns you hope to earn.

Note, too, that there are no particular tax implications for using a sweep account.

Personal Sweeps vs Business Sweeps

Sweep accounts that are linked to your personal accounts work more or less the same as sweep accounts tied to business accounts. They both enable the swift transfer of funds from a low-interest-bearing account to one that potentially generates some income. This can be important for individual investors.

A sweep account is also important for businesses, particularly small businesses that have multiple accounts to handle various payments and cash flows. By setting up a sweep system, it’s possible to manage different income streams and achieve more growth by investing the cash.

You can also sweep money back into the main account if cash is needed to cover expenses, but sometimes this process takes more time. As a business owner, be sure to clarify what the holding periods might be.

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Types of Sweep Accounts

There are a number of different types of sweep accounts. Be sure to inquire at your bank or brokerage about the kinds of sweep accounts they offer, and ask about the terms and any fees that might apply.

•   Individual sweep account: This is typically used by a brokerage to store funds from a client until they decide how to invest the money.

•   Loan payback sweep account: Instead of sweeping the money into a money market or savings account, you can sweep excess funds to help pay off a loan.

•   Business sweep account: This allows you to sweep excess money from business accounts.

•   External sweep account: Some institutions can sweep cash into deposit accounts externally, which can increase the amount of Federal Deposit Insurance Corporation (FDIC) insurance coverage ($250,000 per account).

Pros of Sweep Accounts

As discussed, there are several upsides to sweep accounts, which can include:

•   Helping you earn higher interest rates or possibly investment returns

•   Occurring automatically at the close of each business day, so you don’t have to think about it

•   Possibly being FDIC-insured or protected by the Securities Investor Protection Corporation (SIPC)

Cons of Sweep Accounts

There are also cons to sweep accounts.

•   Your bank or brokerage may charge additional fees for using a sweep account, which might cancel out the interest earned.

•   If your money is swept into a brokerage account, it won’t be FDIC-insured (but it could be covered by the SIPC).

The Takeaway

A sweep account can be a great way to actively increase the amount of interest that you earn if you have multiple accounts. When you use a sweep account, you set a threshold amount that you want to keep in a specific account. Then, at the close of each business day, any excess funds are swept into an account that pays a higher interest rate (e.g., a money market fund).

Sweep accounts offer investors a way to leverage their spare cash. Although returns can vary, and with brokerage accounts, there’s always the risk of loss, sweep accounts provide an important function by putting your cash to work.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with eligible direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

FAQ

Is a sweep account good?

Sweep accounts can be useful if you have multiple accounts with different cash flows. They help ensure your spare cash is always earning the most it can.

Can you lose money in a sweep account?

Not really. A sweep account generally doesn’t hold money itself; it just sweeps funds from one account to another. So a sweep account itself won’t lose money, though it’s possible to lose money, depending on where you sweep the money to.

What is the benefit of a sweep account?

The main benefit of a sweep account is the ability to automatically control how much money is in your various accounts. With this type of account, you can set a minimum threshold for your checking account, for example, and automatically sweep any excess funds into a money market fund at the end of each day.

Photo credit: iStock/Viktor_Gladkov

SOBNK-Q126-080

A confirmed letter of credit can be an important document to those who are launching or running a business, particularly those engaging in international trade. These letters are used to help protect both the buyer and the seller in a business-to-business transaction by adding an extra guarantee that the seller will get paid. It essentially means that a second bank will pay the seller if the first bank fails to do so, which can inspire confidence and allow a deal to go through.

Here’s a closer look at what a confirmed letter of credit is, how it works, and its pros and cons.

What Is a Confirmed Letter of Credit?

Also known as a confirmed LC, a confirmed letter of credit is an additional guarantee for a payment by a secondary bank. It states that this additional bank will be responsible for a payment being on time and in full, even if the buyer doesn’t meet their contractual obligations and the first bank (called the issuing bank) defaults on the payment. You might think of it as a kind of insurance policy or Plan B if the initial bank responsible for payment fails to do its job.

This type of document can be common in international trade, such as transactions between export and import businesses. A guarantee is often required to conduct international transactions or when a vendor or seller has reason to doubt the first bank’s creditworthiness.

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How Confirmed Letters of Credit Work

Confirmed letters of credit, which are signed documents that promise to pay a certain sum to a specified person, are commonly used as negotiable instruments. They can be especially valuable in international business transactions that involve a significant payment amount for goods or services. Since the letter acts as a guaranteed payment, it may take the place of a request for advance payment.

To get a regular letter of credit, the buyer will likely need to submit required documents to the first bank, including proof that certain steps have been completed. Then the bank will send appropriate documents to the seller’s bank. This paperwork shares detailed instructions on the terms and conditions and how payment should be made. Depending on the agreement between the buyer and the seller, payment may be made immediately or at an agreed-upon date.

Once the letter of credit has been issued, the buyer may need the backing of a second bank or a confirmed letter of credit. Worth noting: A fee is likely to be involved. The exact amount of this fee may depend on how good (or questionable) the first bank’s credit is. This letter usually reflects the first letter of credit and uses the same terms.

A confirmed letter of credit can protect both parties because it decreases the risk of default for the vendor or seller. Additionally, it ensures that payment is only made if all the terms are met. It can be a step to building good credit when doing a deal with a new client. It can also be helpful for a business that’s just starting out and making connections, building contacts, and monitoring its credit.

Parties Involved in a Confirmed Letter of Credit

Here’s a list of all the parties typically involved in a confirmed letter of credit.

•   Buyer or applicant: This is the party who is requesting the letter of credit and who will pay the seller.

•   Beneficiary or seller: This is the party who is selling goods or services and the one who receives payment (the payee).

•   Issuing bank: This is usually a bank where the buyer already has a business bank account. It’s the one that issues the original letter of credit.

•   Confirming bank: This is the second bank that will guarantee the funds to the seller once the terms in the letter of credit are met. In some cases, the confirming bank is from the seller’s home country (this may be called a correspondent bank) or is a bank that the seller already works with.

Recommended: Guide to Irrevocable Letters of Credit (ILOC)

Confirmed Letter of Credit Example

Let’s look at a fictional example of how a confirmed letter of credit could work. Say that Pauline’s Paper Goods receives an order for 100,000 pallets of customized notebooks from JessCo, a stationery company. Pauline’s Paper Goods has never worked with JessCo before and isn’t sure that this company has the means to pay for the goods. Maybe Pauline’s Paper Goods worries that JessCo doesn’t have what is considered good credit.

In order to prevent nonpayment after the notebooks are produced and shipped off to the buyer, Pauline’s Paper Goods structures an agreement that JessCo needs to pay with a confirmed letter of credit on the date the shipment leaves its warehouse.

If JessCo agrees, it would start applying for a letter of credit at its bank or depository institution in the U.S., where it has its checking account. If the bank requires it, the company needs to provide proof that it has the funds available or will apply for financing.

As soon as the issuing bank creates the letter of credit, JessCo then applies for a confirmed letter of credit with another bank, possibly the seller’s bank. When Pauline’s Paper Goods receives the completed, confirmed letter, it manufactures and ships the customized notebooks. Once Pauline’s Paper Goods provides proof of when and how the goods were shipped, the guaranteed funds are released.

Recommended: Business vs Personal Checking Account: What’s the Difference?

Confirmed vs Unconfirmed Letters of Credit

If you’re conducting international business, you’ll probably hear the terms confirmed and unconfirmed letters of credit. An unconfirmed letter of credit is simply a letter of credit issued by a bank. A confirmed letter of credit, as we’ve described above, is backed by two banks. Like a bank guarantee, a confirmed letter of credit can foster trust if, say, there’s reason to worry that the payment won’t be made.

Here’s a look at some other differences between a confirmed vs. an unconfirmed letter or credit.

•   Guaranteed payment: With an unconfirmed letter of credit, the issuing chartered bank or financial institution guarantees payment. With a confirmed letter of credit, however, two banks confirm payment.

•   Cost: Unconfirmed letters of credit tend to cost less than confirmed letters of credit.

•   Changes: The buyer is allowed to make changes to an unconfirmed letter of credit. With a confirmed letter of credit, both banks can modify the document.

•   Issuance: The seller only has to approach one bank for an unconfirmed letter of credit but needs to contact two banks with a confirmed letter of credit.

Recommended: Guide to a Commercial Letter of Credit

Advantages of Confirmed Letters of Credit

Confirmed letters of credit can have several benefits for sellers, particularly those doing business internationally and wanting to ensure smooth transactions. These advantages include:

•   Protection for both the buyer and seller

•   An extra layer of confidence for the seller

•   A lower risk of default thanks to a reputable second bank (perhaps serving as a guarantor if the first bank has a low credit rating)

•   Enhanced buyer credibility, which may increase the odds that a seller will do business with them

Disadvantages of Confirmed Letters of Credit

While confirmed letters of credit can be very valuable in business, there are a couple of downsides to recognize. Disadvantages of confirmed letters of credit include:

•   It may take longer to get a confirmed letter of credit since an additional bank is involved.

•   Bank fees may be higher than with an unconfirmed letter of credit.

The Takeaway

A confirmed letter of credit can be a valuable business tool, especially when conducting international business. For those importing or exporting, the letter will guarantee payment for goods a company is supplying if the buyer and the buyer’s bank can’t complete the deal. Getting a confirmed letter of credit can cost more and take longer compared to an unconfirmed letter of credit, but the effort may be worth it. It can secure a transaction and open doors to doing business with new customers in a way that communicates confidence.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with eligible direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

FAQ

What is an unconfirmed letter of credit?

An unconfirmed letter of credit is a letter of credit that’s only been issued by one bank, known as the issuing bank. In a transaction, the buyer requests an unconfirmed letter of credit to guarantee funds will be paid on time to the seller by the bank.

Is an unconfirmed LC safe?

Yes, an unconfirmed letter of credit (LC) is safe because there is a guarantee or confirmation from one bank that payment will be made. Assuming that the issuing bank has a high credit rating, the seller can feel confident that the funds will be paid once all the conditions in the contract have been met. If the seller wants an additional layer of security, they may request a confirmed letter of credit, which means a second bank will provide payment if the first one fails to do so.

What is the risk of an unconfirmed LC?

The risk of an unconfirmed letter of credit (LC) is that the issuing bank won’t have the funds to pay the seller. That means that even if the seller completes their end of the contract, they risk losing out on funds if the issuing bank doesn’t fulfill its promise.

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A bank guarantee is a promise by a financial institution that it will assume liability for a business contract if one party fails to uphold its obligation to another. In this way, the bank acts like a cosigner for a buyer or borrower on a business agreement, reducing the risk for the seller or lender.

This can be a valuable assurance for organizations that are conducting financial transactions. For a small fee, bank guarantees often enable small businesses to enter into contracts with larger companies with which they otherwise wouldn’t be able to do business. Read on to learn more about how bank guarantees work and their pros and cons.

What Is a Bank Guarantee?

A bank guarantee promises that, if one party in a business agreement fails to meet its obligations, the bank will cover its debts. Backing up a transaction adds confidence to riskier deals.

Bank guarantees involve a thorough review of the business applicant’s finances and credentials. If, after this due diligence, a commercial bank feels confident that an applicant (the debtor) will be able to uphold their contractual obligations, the bank may offer the guarantee to the other party (the beneficiary). This can lead to greater assurance that the transaction will go smoothly.

Bank guarantees are usually a part of more complex financial transactions between businesses. While they’re not limited to business customers, bank guarantees are not generally used for auto loans, mortgages, or personal loans.

Here are some more details about bank guarantees for the business clients of a financial institution:

•   Companies often use bank guarantees for complicated contracts involving goods and services. If a vendor fails to provide goods or services that have already been paid for, a bank guarantee ensures reimbursement for the business using that vendor.

•   If, on the other hand, a buyer fails to pay for goods or services that have already been delivered or rendered, the bank guarantee covers the unpaid balance for the seller.

•   Since a bank guarantee can protect either a buyer or a seller, it’s helpful to think of them in terms of the beneficiary (the company that requires a bank guarantee to feel protected and move forward with a contract) and the applicant (the company that applies for the bank guarantee to close the deal).

How Do Bank Guarantees Work?

If a contract includes a bank guarantee, that guarantee will specify an amount to be repaid (or the goods or services to be delivered) and a set timeframe for the transaction. The contract will also spell out the bank’s responsibility should the applicant fail to meet their contractual obligations.

To assume this risk, banks charge applicants a fee for the guarantee, expressed as a percentage of the cost or value of the transaction, typically around 0.5% to 1.5%.

If the bank deems a contract particularly risky, it might require the applicant to offer collateral. Unlike with secured personal loans, where a house or car might serve as collateral, bank guarantee collateral is typically liquid assets, such as stocks or bonds.

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Types of Bank Guarantees

There are two main types of bank guarantees: financial bank guarantees and performance guarantees.

Financial Bank Guarantee

With a financial bank guarantee, a bank promises to repay a debt if the borrower (or buyer) defaults on the agreement. For example, an applicant may purchase goods and services from a large company, receive those goods and services, and never pay the bill. In this instance, the bank would settle the debt with the large company since the funds can’t come out of the borrower’s bank account.

What Is a Performance Guarantee?

In this situation, if an applicant fails to perform the obligations laid out in the contract (e.g., supplying parts to a company), the beneficiary can make a claim with the bank for the losses incurred from the non-performance of contractual obligations.

Performance failure might also mean that although the goods or services were delivered, they didn’t meet the quality standards specified in the contract. In these situations, the bank would step in to offset those losses.

Examples of Bank Guarantees

Bank guarantees can serve many purposes, usually between two businesses. Here are a few of the guarantees that banks often issue:

Rental Guarantee

A rental guarantee protects a landlord when entering into a contract with a company (such as a restaurant or retailer) that wants to lease a space. This guarantee serves as collateral for a rental lease.

Advanced Payment Guarantee

An advanced guarantee protects a company that has paid in advance for goods or services that weren’t delivered. You may also hear this referred to as a cash guarantee. If the deal isn’t satisfied, the company that has paid out in advance will be refunded.

Performance Bond Guarantee

A performance bond is a kind of financial guarantee for a business deal to protect against one party failing to meet its obligations. You may also hear this called a contract bond. If, say, a contractor doesn’t complete the work they agreed to do, a performance bond guarantee can protect the party paying for the project. That entity would be compensated for its loss.

Warranty Bond Guarantee

When a bank provides a warranty bond guarantee, it protects the buyer in a transaction during a specified warranty period, ensuring that goods are delivered as specified. This could refer to the quality and condition of the items, as well as the timing of their arrival.

You may also hear this term used in another situation. Sometimes referred to as a maintenance bond, a warranty bond guarantee can be a financial guarantee in which a builder promises to protect the owner of a construction project from problems with workmanship or faults with materials that could occur after the project’s completion. A financial institution or insurer will back up this promise.

Payment Guarantee

A payment guarantee is quite simply what it sounds like: It guarantees that if, say, a buyer fails to send adequate funds for a purchase, the bank will step in and cover the shortfall. It allows a seller to feel confident that they’ll be paid in full on a predetermined date.

Recommended: Bank Guarantees vs Letters of Credit: What’s the Difference?

Pros and Cons of Bank Guarantees

Here’s what you need to know about the upsides and downsides of bank guarantees.

Pros

Among the most important advantages of a bank guarantee are the following:

•   Reduced costs: While not free, a bank guarantee can be a cost-effective way to encourage confidence and help a deal go through. It may be less expensive to obtain than taking out a small business loan to cover a potential debt, for example.

•   Reduced risk: A bank guarantee reduces risk since the bank promises to pay if one party doesn’t hold up their end of the deal. In this way, a bank guarantee can open up new opportunities for businesses, especially those without a long or solid credit history.

•   Quick activation: It typically takes only a few days to obtain a bank guarantee.

•   Enhanced credibility: Before offering a guarantee, a bank does a comprehensive assessment of an applicant’s financial standing. Earning a bank’s backing through a guarantee demonstrates that the bank finds the applicant company to be credible.

Cons

The potential drawbacks of bank guarantees to be aware of are:

•   Stringent approval guidelines: Bank guarantees aren’t given to just any entity. A business must show that it merits this backing. Not every applicant will qualify.

•   Strict collateral requirements: If a venture seems particularly risky, banks may require collateral from applicants. This can be risky for startups with limited funding.

•   Complex regulations: There have been scams involving bank guarantees in some international transactions. Using a bank guarantee for an international deal may therefore require many complex steps and assurances before it moves forward.

The Takeaway

In business transactions, a bank guarantee promises that the financial institution will cover any debts to one party if the other party doesn’t meet its obligations. Larger companies often require small businesses and startups to obtain a bank guarantee before doing business with them. These guarantees can help a small or new business secure large deals since the bank has shown confidence in them.

That said, if you’re focused on your personal finances and are considering your options, see what SoFi offers.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with eligible direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

FAQ

What is the difference between bank guarantees and letters of credit?

Both bank guarantees and letters of credit add confidence to business deals, with slight differences. With a bank guarantee, the financial institution promises to step in and pay debts, if needed, for the party it guaranteed. A letter of credit, which is useful in international trade, substitutes the bank’s credit for a business’, which means the bank will guarantee payment if the business defaults on its obligation, but only once certain criteria are met.

What is the purpose of a bank guarantee?

The purpose of a bank guarantee is to add confidence to a contract between two parties. If one party fails to uphold its contractual obligations or defaults on a loan, the bank promises to step in and uphold the contract and pay the debt that may result.

How can I get a bank guarantee?

If a business requires a bank guarantee to enter into a contract, contact your bank (or your business’ bank) and request an application. The bank will then review the completed application to determine your creditworthiness, typically within a few business days.

Photo credit: iStock/eclipse_images

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