What is a letter of credit?

A letter of credit is a written agreement between the seller, the buyer, and the banks regarding the terms and conditions of payment for goods or services. The letter of credit helps reduce risks for both the buyer and the seller and is common in international trade.

Definition and Example of a Letter of Credit

A letter of credit is a document that outlines the agreed terms and conditions for a commercial transaction between the buyer and the seller. Banks act as a third-party intermediary for the sale and guarantee payment in case the buyer fails to meet their obligations. There are different types of letters of credit that provide various types and levels of security for buyers and sellers.

For example, a seller receiving a sale from an importer may require payment using a letter of credit. The importer would then work with a bank in their country to obtain the letter of credit. This bank will send the letter of credit to the seller’s bank in the seller’s country. The seller will then ship the goods according to the terms outlined in the letter of credit. Once the banks agree that all conditions have been met, payment for the products is made.

Knowing that letters of credit are one of the safest payment options, they can, however, be time-consuming and costly. For example, the buyer must pay a fee to their bank for obtaining the letter of credit.

How a Letter of Credit Works

Letters of credit can be very safe payment methods and are often recommended for use in situations that carry more risk, including:

• If payment terms are unconventional
• If the buyer is a new customer
• If the seller cannot verify the credit of the importer or if they have a poor credit history

The importer also benefits from the security provided by the letter of credit, as the seller must present documents proving that the goods have been shipped according to the agreed terms in order to be paid.

Recommendation: Ensure that trained professionals are used to prepare the documents for the letter of credit – the necessary documentation can be complex, and mistakes can lead to fees or delayed payment.

Example of a Letter of Credit Process

Here is a step-by-step illustrative example of how the letter of credit process works:

1. A letter of credit can be used in a sale between a buyer and a seller located in different countries to ensure smooth delivery of goods and payment. The importer opens a letter of credit with their bank to pay the seller. The importer’s bank sends the letter of credit to the seller’s bank, which in turn sends it to the seller. The seller ships the products and submits the documents to the seller’s bank. The bank confirms that the seller has fulfilled their obligations according to the terms agreed upon in the letter of credit. The seller’s bank guarantees payment from the buyer’s bank to be delivered to the seller. The buyer pays their bank for the products, and the bank issues the documents so that the buyer can claim the goods and clear customs.

Recommendation: Letters of credit can be used for individual sales or arranged to be ongoing and include multiple transactions.

Types of Letters of Credit

There are different types of letters of credit available. Below are some common features you will find in these letters:

• Sight or term payment: This specifies whether the seller will be paid upon presentation of all necessary documents – a sight letter of credit. Or at a later time as agreed in the sales contract – a term letter of credit.
• Revocable or irrevocable: A revocable letter of credit allows the issuing bank to terminate or modify the letter of credit at any time without notifying the seller. Most letters of credit are irrevocable, meaning the contract cannot be changed or terminated without the consent of all parties involved.
• Confirmed
  or uncertain: A confirmed letter of credit is issued when the buyer’s bank authorizes a bank at the seller’s location to also confirm the transaction. It provides additional security – in the event that the buyer’s bank does not fulfill its obligations, the bank at the seller’s location will pay the seller. In contrast, if there is no bank at the seller’s location, there is no protection for the transaction in the case of an unconfirmed letter of credit.

Recommendation: A letter of credit is a document from a bank that guarantees a commercial transaction between the buyer and the seller. This letter is used in international trade. It is a very secure payment option, but it can be costly and relatively time-consuming. The document outlines the agreed-upon terms and conditions for payment in the sales process, with banks acting as third-party intermediaries and ensuring payment in case the buyer fails to meet their obligations.

Source: https://www.thebalancemoney.com/what-is-a-letter-of-credit-5213863