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 transferrable, 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.

  1. Straight Credit

    Straight credit is a form of letter of credit, which banks may ...
  2. Interpretive Letter

    A letter issued by banking regulators that interprets the banking ...
  3. Letter Of Comfort

    A letter of comfort is a written document that provides a level ...
  4. Credit Reference

    A credit reference can be a report from a credit agency for either ...
  5. Attorney's Letter

    A letter sent by a CPA to the client's attorney. The attorney's ...
  6. Bank Credit

    Bank credit is the amount of credit available to a company or ...
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

    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.
  3. Financial Advisor

    Your Advisor and Myths of International Investing

    Wall Street touts diversification and improving portfolios via investing in international equities. But do we know the whole story they're selling?
  4. Small Business

    How To Increase Your Appeal To Prospective Lenders

    Making a business eligible for loans/credit cards at the best possible rates requires crafting an excellent credit profile through the smart use of credit.
  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

    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.
  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. 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

    Should Your Credit Rating Scare You?

    Take the mystery out of credit scores by learning the most important ways it can impact your life.
  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. When are you legally required to get a letter of credit?

    Learn how exporters or importers who deal in international trade use letters of credit to ensure that transactions are safe, ... Read Answer >>
  3. Can entities other than banks issue letters of credit?

    Obtaining a letter of credit from a non-bank is legally acceptable according to the ICC, but companies tend to prefer to ... Read Answer >>
  4. What content does a letter intent have to have?

    Review some of the standard language that ought to be included in a letter of intent between two parties in a business transaction. Read Answer >>
  5. 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 >>
Trading Center