A:

Letters of credit are important assurances or guarantees to sellers that they will be paid for a large transaction, particularly with international 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 contemporary letters of credit 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 others.

Commercial letters of credit, sometimes referred to as import/export letters of credit, are prominent in completing 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.

Other Types

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.

Agreed to By Both Parties 

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 you acquire a letter of credit for any transaction, make sure that you communicate with the other party in detail before either of you submit an application. Ask for a copy of any application so that you can review the terms and conditions. Be aware of deadlines, including the expiration date of the credit and any time allowance granted between the dispatch and presentation.

Even though most letters of credit involve international exchange, they can be used to help facilitate any kind of trade. Before agreeing to to back a letter of credit, a financial institution is likely to review your credit history, assets and liabilities, and attempt to identify 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.
 

RELATED FAQS
  1. How legally binding is a letter of intent?

    Find out when a letter of intent (LOI) is binding and non-binding. Understand the role of drafting language, and when an ... Read Answer >>
  2. What do the letters / symbols on credit ratings mean?

    Learn about the numbers, letters and symbols used to express credit ratings and credit scores. Understand what these symbols ... Read Answer >>
  3. What is the difference between a letter of intent and a memorandum of understanding?

    Understand what a letter of intent and a memorandum of understanding are, and learn the primary difference between the two ... Read Answer >>
  4. What's the difference between a credit rating agency and a credit bureau?

    Learn how to differentiate between credit rating agencies and credit bureaus, two industries that distribute valuable risk ... Read Answer >>
Related Articles
  1. Investing

    7 Tips for Writing a Homebuyer’s Letter to a Seller

    To win a real estate bidding war, use these seven tips for writing a homebuyer’s letter to a seller that’s engaging and personal.
  2. Personal Finance

    6 Ways To Build Credit Without A Credit Card

    It's definitely possible – if a bit more complicated – to build a credit history without traditional credit cards. Just follow these steps.
  3. Investing

    Revolving Credit vs. Line of Credit

    Revolving credit and a line of credit are arrangements made between a lending institution and a business or individual.
  4. Personal Finance

    Build Your Credit Score

    Here are four good ways to build your credit score when you're starting from scratch. Do it right and you'll end up with excellent credit.
  5. Personal Finance

    Is Your Credit Score at 850? It Can Be!

    Use these tips to increase your credit score and your ability to get low interest rates on loans.
  6. Personal Finance

    How To Dispute Errors On Your Credit Report

    It just takes some time and effort to rebound from a nasty case of "credit rejection shock."
  7. Personal Finance

    How Your Credit Score Compares to the Average American's

    While only a small percentage of Americans have terrible credit scores, a whopping 30% have poor or bad credit, according to the Consumer Financial Protection Bureau.
  8. Managing Wealth

    5 Common Misconceptions About Your Credit Report

    Your credit report is one of the most important factors in determining your ability to get loans and new credit and has a major influence on your rates.
  9. Personal Finance

    Should you increase your credit card limit?

    Understand the fundamentals between credit scores, credit card limit, and your credit utilization rate. Find out why you should ask for your credit limit increase and the benefits that follow.
RELATED TERMS
  1. Confirmed Letter of Credit

    A confirmed letter of credit is a letter of credit with a second ...
  2. Bank Confirmation Letter - BCL

    A bank confirmation letter is a letter confirming that a line ...
  3. Shareholder Letter

    A shareholder letter is a letter written by a firm's top executives ...
  4. Letter Of Guarantee

    A letter of guarantee is typically issued by a bank, letting ...
  5. Cover Letter

    A cover letter is submitted with a job application and resume ...
  6. Letter Of Comfort

    A letter of comfort is a written document that provides a level ...
Hot Definitions
  1. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  2. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  3. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  4. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  5. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  6. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
Trading Center