An irrevocable letter of credit (or ILOC) is a written agreement between a bank and the party to which the letter is issued. Irrevocable letters of credit are used to guarantee a buyer’s obligations to a seller.
Irrevocable letters of credit can be used in different types of financial arrangements to ensure that a seller will be paid, even if the buyer fails to uphold their end of the bargain. These letters of credit are often central to international transactions, though there are other situations where using one might be appropriate.
Here, we’ll review:
• What an irrevocable letter of credit is
• How an ILOC works
• When you might need an irrevocable letter of credit
• Alternatives to ILOCs
What Is an Irrevocable Letter of Credit?
If you are wondering, “What is an irrevocable letter of credit?” a definition may help. An irrevocable letter of credit represents an agreement between a bank and a buyer involved in a financial transaction. The bank guarantees payment will be made to the seller according to the terms of the agreement. Since the letter is irrevocable, that means it cannot be changed without the consent and agreement of all parties involved.
Irrevocable letters of credit can also be referred to as standby letters of credit. Once an irrevocable letter of credit is issued, all parties are contractually bound by it.
This means that even if the buyer in a transaction doesn’t pay, the bank is obligated to make payment to the seller to satisfy the agreement.
Having an irrevocable letter of credit in place is a form of credit risk management. The seller is guaranteed payment from the bank, which can help to reduce concerns about the buyer failing to pay. And it ensures that the seller will follow through on their obligations by providing whatever is being purchased through the agreement. In simpler terms, a standby letter of credit or irrevocable letter of credit is a sign of good faith on the part of everyone involved in a transaction.
How Does an Irrevocable Letter of Credit Work?
Here’s how an irrevocable letter of credit works. It establishes a contractual agreement between a buyer, a seller, and their respective banks. It effectively creates a safeguard for both the buyer and the seller, in that:
• Buyers are not required to forward payment until the seller provides the goods or services that have been purchased.
• Sellers can collect payment for goods and services, as long as the conditions outlined in the letter of credit are met.
The bank issuing the letter of credit acts as a go-between for both sides, guaranteeing payment to the seller even if the buyer doesn’t pay. Assuming the buyer does fulfill their obligations, they would then make payment back to the bank. In a sense, this allows the buyer to borrow from the bank without formally establishing credit in the form of a loan or credit line. (Check with your financial institution to learn what fees may be involved. After all, transaction fees are how banks earn money.)
Before an irrevocable letter of credit is issued, the bank will first verify the buyer’s creditworthiness. Assuming the bank is reassured that the buyer will, in fact, repay what’s owed to complete the purchase, it will then establish the irrevocable letter of credit to facilitate the transaction between the buyer and seller. Irrevocable letters of credit are communicated and sent through the SWIFT banking system.
Recommended: How Exactly Do Banks Make Money?
Irrevocable Letter of Credit Specifications
The exact details included in an irrevocable letter of credit can depend on the situation in which it’s being used. The conditions that are set for the completion of the transaction will also matter. But generally, you can expect an irrevocable letter of credit to include:
• Buyer’s name and banking information (that is, their bank account and other details)
• Seller’s name and banking information
• Name of the intermediary bank issuing the letter of credit
• Amount of credit that’s being issued
• Date that the letter of credit is issued and the date it will expire
An irrevocable letter of credit will also detail the conditions that must be met by both the buyer and seller in order for the contract to be valid (and thereby prove the transaction’s creditworthiness). For example, the seller may need to provide written verification that the goods or services referenced in the agreement have been provided before payment can be issued. The letter of credit must be signed by an authorized bank representative. It may need to be printed on bank letterhead to be valid.
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Do I Need an Irrevocable Letter of Credit?
You may need an irrevocable letter of credit if you’re doing business with someone in a foreign country. You may also require one if you are conducting a transaction with a new company or individual (one with which you don’t yet have an established relationship). Irrevocable letters of credit can help to mitigate some of the risk that goes along with international transactions. These letters ensure that if you’re the seller, you get paid for any products or services you’re providing. They also protect you if you’re the buyer, promising that products or services are delivered to you.
An irrevocable letter of credit could also come in handy if you’re still working on building credit for your business and you’re the buyer in a transaction. The bank will pay the money to the seller; you’ll then repay the bank. Payment may be required in a lump sum from your business bank account or another source. Or the bank may also offer the option of repaying it in installments over time. Repaying your obligation could help to raise your business’s creditworthiness in the bank’s eyes. This may make it easier to take out other loans or lines of credit later.
Recommended: How Does a Business Bank Account Work Differently than a Personal Checking Account?
Alternatives to Irrevocable Letters of Credit
An irrevocable letter of credit is not the only way to do business when engaging in international transactions. You may also consider trade credit insurance or another type of letter of credit instead.
Trade Credit Insurance
Trade credit insurance, also referred to as accounts receivable insurance or AR insurance, is used to insure businesses against financial losses resulting from unpaid debts. (Debts could lead you to secure a personal business loan.) You can use trade credit insurance to cover all transactions or limit them to ones where you believe there may be a heightened risk of loss, such as transactions involving foreign businesses.
A trade credit insurance policy protects your business in the event that the other party to a financial agreement defaults. It can insulate your accounts receivable against losses if an unpaid account turns into a bad debt. Purchasing trade credit insurance may be an easier way to manage risk for your business overall, as it’s less involved than an irrevocable letter of credit.
Letters of Credit
A letter of credit guarantees payment from the buyer’s bank to the seller’s bank in a financial transaction. Like an irrevocable letter of credit, it establishes certain conditions that must be met in order for the transaction to be completed. But unlike an irrevocable letter of credit, a standard letter of credit can be revoked or modified.
You might opt for this kind of letter of credit if you’re doing business with someone you don’t know and you want reassurance that the transaction will be completed smoothly. A regular letter of credit may also be preferable if you’d like the option to modify or cancel the agreement.
The Takeaway
An irrevocable letter of credit is something you may need to use from time to time if you run a business and regularly deal with international transactions. It adds a layer of protection to buying and selling, as a bank is saying it will cover the transaction. An ILOC, as it’s sometimes known, can provide reassurance when working with a new business or establishing your company overseas. The letter cannot be changed, so you’re getting solid peace of mind.
If your money management tasks are limited to your personal finances, on the other hand, opening a new bank account online is a simpler solution for paying bills and making purchases.
With SoFi banking, you can earn a competitive rate on savings. SoFi doesn’t charge any fees and you can conveniently manage your accounts online or from your mobile device. Plus, you can get paid up to two days early when you enroll in direct deposit and earn a competitive APY.
FAQ
What is the difference between a letter of credit and an irrevocable letter of credit?
A letter of credit and irrevocable letter of credit are largely the same, in terms of what they’re designed to and in what situations they can be used. The main difference is that unless a letter of credit specifies that it is irrevocable, it can be changed or modified by the parties involved.
What is the cost of an irrevocable letter of credit?
Transaction fees help banks make money so it should be no surprise that you’ll likely pay a fee for an irrevocable letter of credit. The fee is typically set as a percentage of the transaction amount, though the rate you’re charged can vary from bank to bank.
Does an irrevocable letter of credit expire?
An irrevocable letter of credit can have an expiration date. If the letter is set to expire, the date should be spelled out clearly in the agreement.
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