Loading the player...

What is a 'Letter Of Credit'

A letter of credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.

BREAKING DOWN 'Letter Of Credit'

Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.

Funding a Letter of Credit

Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit. Banks also collect a fee for service, typically a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.

Example of a Letter of Credit

Citibank offers letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia and the Middle East who may have difficulty obtaining international credit on their own. Citibank’s letters of credit help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk. Letters of credit are typically provided within two business days, guaranteeing payment by the confirming Citibank branch. This benefit is especially valuable when a client is located in a potentially unstable economic environment.

Types of Letters of Credit

A commercial letter of credit is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.

A revolving letter of credit lets the customer make any number of draws within a certain limit during a specific time period. A traveler’s letter of credit guarantees the issuing banks will honor drafts made at certain foreign banks.

A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. The issuing bank in international transactions typically requests this arrangement.

RELATED TERMS
  1. Confirmed Letter of Credit

    A confirmed letter of credit is a letter of credit with a second ...
  2. Bank Letter Of Credit Policy

    A bank letter of credit policy allows banks to verify letters ...
  3. Bank Confirmation Letter - BCL

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

    A shareholder letter is a letter written by a firm's top executives ...
  5. Credit Reference

    Credit references can be a credit report or documented letter ...
  6. Cover Letter

    A cover letter is submitted with a job application and resume ...
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. Personal Finance

    The Importance Of Your Credit Rating

    A great starting point for learning what a credit score is, how it is calculated and why it is so important.
  4. Personal Finance

    Take the Right Steps to Build Excellent Credit

    There are several things you can do to protect and improve your credit score.
  5. Personal Finance

    Why You Should Improve Your Credit and How to Do It

    With credit playing a big role in many financial decisions, it is important to maintain good credit.
  6. Personal Finance

    Best Credit Cards For International Students

    International students studying in the U.S. can establish credit history and get a locally issued credit card.
  7. Personal Finance

    Analyzing a Career in Credit Analysis

    If you're a number-cruncher and responsibility doesn't scare you, this could be the job for you.
  8. 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.
  9. 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."
  10. Small Business

    Small Business Loan Vs Line of Credit: How They Differ

    Understand the differences between a small business loan and a line of credit, and learn some of the most appropriate uses for each form of financing.
RELATED FAQS
  1. What are the different types of letters of credit?

    Learn more about the different types of letters of credit that are used to facilitate exchanges between parties that might ... Read Answer >>
  2. What's the difference between a bank guarantee and a letter of credit?

    Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction ... 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 >>
Trading Center