What Is a Letter of Credit?

A letter of credit, or "credit letter" 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 a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. It may be offered as a facility.

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.

Key Takeaways

  • A letter of credit is a document sent from a bank or financial institute that guarantees that a seller will receive a buyer's payment on time and for the full amount.
  • Letters of credit are often used within the international trade industry.
  • There are many different letters of credit including one called a revolving letter of credit.
  • Banks collect a fee for issuing a letter of credit.

How a Letter of Credit Works

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.

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. There are several types of letters of credit available.

Types of Letters of Credit

Commercial Letter of Credit

This 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.

Revolving Letter of Credit

This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period.

Traveler's Letter of Credit

For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.

Confirmed Letter of Credit

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.

An 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.

Frequently Asked Questions

What is a letter of credit?

Often in international trade, a letter of credit is used to signify that a payment will be made to the seller on time, and in full, as guaranteed by a bank or financial institution. By sending a letter of credit, the bank will charge a fee, typically a percentage of the letter of credit, in addition to requiring collateral from the buyer. Among the various forms of letters of credit are a revolving letter of credit, commercial letter of credit, and confirmed letter of credit.

What is an example of a letter of credit?

Consider an exporter in an unstable economic climate, where credit may be more difficult to obtain. The Bank of America would offer this buyer a letter of credit, available within two business days, in which the purchase would be guaranteed by a Bank of America branch. Because the bank and the exporter have an existing relationship, the bank is knowledgeable of the buyer's creditworthiness, assets, and financial status. 

What is the difference between a commercial letter of credit and a revolving letter of credit?

As one of the most common forms of letters of credit, commercial letters of credit are when the bank makes payment directly to the beneficiary, or seller. Revolving letters of credit, by contrast, can be used for multiple payments within a specific time frame. Typically, these are used for businesses that have an ongoing relationship, with the time limit of the arrangement usually spanning one year.