A letter of credit is a business-to-business document guaranteeing that the provider of goods or services to a buyer will receive payment. As part of a sales agreement, a seller may require the buyer to deliver a letter of credit before a deal takes place.
More specifically, letters of credit are often vital in international trade where the two parties involved are not yet familiar with one another. Letters of credit facilitate new trade and prompt 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?
Here’s what a letter of credit in banking is: It’s a document that a bank issues to a seller that guarantees payment from their 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. 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. It’s not necessarily a matter of the buyer having a bad credit score. Rather, the deal may involve different legal frameworks, a lack of familiarity between the parties involved, and geographic distance.
How a Letter of Credit Works
When used properly, letters of credit can work to minimize credit risk and smooth international trade. A vendor selling products or services overseas may want assurance that a buyer of their products or services will pay. Perhaps the buyer is new to them or just a new business, period.
So how does a letter of credit work? It serves as a guarantee from a bank that it will pay 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 can help the business placing the order build their credit, too.
The bank charges the buyer a fee for issuing a letter of credit (often around 0.75% to 1.5% of the amount of the deal), but it also does the due diligence to assure creditworthiness. The bank requires collateral or security from the buyer for the 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
The following are four types of letters of credit.
• Commercial Letter of Credit: The issuing bank pays the seller directly. For a stand-by letter of credit, the bank only pays the seller if the buyer cannot transfer funds.
• Revolving Letter of Credit: The bank guarantees payment for a number of transactions within a set period.
• Traveler’s Letter of Credit: Travelers can make withdrawals in a foreign country. The issuing bank guarantees to honor any withdrawals.
• Confirmed Letter of Credit: A seller using a confirmed letter of credit involves a secondary bank, typically the seller’s bank. They guarantee payment if the first bank fails to pay.
You may also hear an irrevocable letter of credit mentioned; this is a letter of credit that can’t be changed or canceled unless all parties agree.
There is also a stand-by letter of credit which may be used when deal requirements are not initially met; see below for more details.
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Letter of Credit Example
Here’s an example of a letter of credit: Wells Fargo provides commercial letters of credit and stand-by letters of credit within two weeks. The funds are secured through deposits at Wells Fargo, and the terms are renewable. These documents can help reassure parties doing business internationally, with new-to-them businesses or clients who have recently started a business.
The Money Behind a Letter of Credit
When it comes to letters of credit, you may wonder, Where do the payment funds for a letter of credit originate? The party paying for the goods or services typically deposits funds in advance to 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 in the case of international trade. In the latter case, shipping documents would serve as proof that the requirements for payment have been fulfilled. They might 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 may be using letters 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: The party or the acquirer of products or services who applies for the letter of credit from the bank.
• Beneficiary: The party, or seller, who will receive payment. The seller usually requests a letter of credit to guarantee payment.
• Confirming bank: The bank that guarantees the payment of the required funds to the seller. If a third party is involved, the confirming bank is the bank most familiar to the seller.
• Freight forwarder: A 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: 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 to complete the transaction.
• Shipper: The transportation company that ships goods.
• Stand-by letter of credit: A subsequent 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 stand-by 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.
| Pros | Cons |
|---|---|
• Reduces the risk that payment will not be made for goods or services, thereby providing security • Allows for additional requirements to be built into a letter of credit, such as quality control and delivery stipulations • Provides transaction security for both the buyer and the seller • Forges new trade relationships | • Incurs bank fees for the letter of credit, which increases the cost of doing business • Adds time by preparing a letter of credit; transactions can be delayed • May require a separate letter of credit for each transaction • Demands that the buyer usually provide collateral to the bank |
How to Get a Letter of Credit
Getting a letter of credit typically 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 of lading, 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 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 and provides 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 trade relationship or an 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 priceless peace of mind when conducting international trade or doing business with a new customer.
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FAQ
How much does a letter of credit cost?
A typical fee for a letter of credit is typically 0.75% percent to 1.5% of the amount of the deal, but the rate will vary depending on the country and other variables.
How do you apply for a letter of credit?
Once the terms of a trade are agreed upon between the buyer and the seller, a 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 the buyer confirms their creditworthiness as a trade partner.
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