What Is a Letter of Credit?
Letters of credit are assurances or guarantees to sellers that they will be paid for a large transaction. They are particularly common in international or foreign exchanges.
Think of them as a form of payment insurance from a financial institution or another accredited party to the transaction. The very first letters of credit, common in the 18th century, were known as travelers' credits.
The most common types of letters of credit today are commercial letters of credit, standby letters of credit, revocable letters of credit, irrevocable letters of credit, revolving letters of credit, and red clause letters of credit, although there are several other types of letters of credit.
- Letters of credit guarantee sellers that they will be paid for a large transaction.
- Banks and financial institutions typically take on the responsibility of ensuring that the seller is paid.
- Such documents are commonly used in international or foreign exchange transactions.
- Types of letters of credit include commercial letters of credit, standby letters of credit, and revocable letters of credit.
- Other types of letters of credit are irrevocable letters of credit, revolving letters of credit, and red clause letters of credit.
Types of Letters of Credit
Commercial letters of credit, sometimes referred to as import/export letters of credit, are prominent in the completion of international trades. The International Chamber of Commerce published a Uniform Customs and Practice for Documentary Credits (UCP) with which the majority of commercial letters of credit comply.
Standby letters of credit work slightly differently than most other types of letters of credit. If a transaction fails and one party is not compensated as it should have been, the standby letter is payable when the beneficiary can prove it did not receive what was promised. This is used more as insurance and less as a means of facilitating an exchange.
Revocable letters of credit create leverage for the issuer. It is contractually legal for one party to either amend or cancel the exchange at any time, normally without the consent of the beneficiary. These types of letters are not seen very frequently since most beneficiaries do not agree to them, and the UCP has no provision for them
Irrevocable letters of credit are more common than revocable ones. These stipulate that no amendments or cancellations can occur without the consent of all parties involved. Irrevocable letters of credit can either be confirmed or unconfirmed.
Confirmed letters require that another financial institution guarantees the payment, which is usually the case when the beneficiary does not trust the other party's bank.
Revolving letters of credit are designed for multiple uses. They can be used for a series of payments. These are common among individuals or businesses that expect to do business together on an ongoing basis. There is usually an expiration date attached to these letters of credit, often one year.
Red clause letters of credit contain an unsecured loan made by the buyer, which acts as an advance on the rest of the contract. Sometimes one party requests a red clause letter of credit to obtain the funding necessary to buy, manufacture, or transport the goods involved in the transaction.
How a Letter of Credit Works
Every letter of credit, regardless of type, is written in an official document agreed to by both parties before it is submitted to the guaranteeing financial institution for review.
Before a letter of credit is acquired for any transaction, both parties must clearly communicate with each other before submitting an application. Both parties must review the terms and conditions on the application and be aware of deadlines, including the expiration date of the credit and any time allowance granted between the dispatch and presentation.
Although most letters of credit involve international exchange, they can be used to help facilitate any type of trade. Before agreeing to back a letter of credit, a financial institution is likely to review the applicant's credit history, assets, and liabilities and attempt to find proof that the seller has a legitimate operation.
The buyer often has an existing relationship with the bank. The bank is, therefore, aware of the party's creditworthiness and general financial status. If the buyer is unable to pay the seller, the bank is responsible for making the full payment. If the buyer has made a portion of the payment, the bank is responsible for paying the remainder.
How Do I Get a Letter of Credit?
You can get a letter of credit from your bank, although smaller banks may not offer letters of credit. You will likely have to get a letter of credit through the bank's international trade department or commercial division.
How Much Does a Letter of Credit Cost?
The cost of a letter of credit will vary by bank. Generally it can cost a few percentage points, such as between about 0.75% and 1.5% of the value of the transaction. The amount may be based in part on your credit history.
What Is the Purpose of Letter of Credit?
A letter of credit is used in a business transaction to guarantee that a payment will be made. It is issued by a bank.
The Bottom Line
Letters of credit helps establish that payment will be made in a business transaction. The various types of letters of credit include commercial letters of credit, standby letters of credit, revolving letters of credit and much more.