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A letter of credit is a legal document from a bank or financial institution. It represents a promise to pay the holder, if the holder fulfills certain obligations. Sellers in commercial transactions often require buyers to give them a letter of credit before they ship goods, because a bank then takes on the obligation of paying the seller, thus ensuring that the seller will be paid.

Letters of credit, or LOCs, are often used when buyers and sellers do not know each other. They are especially common in international trade when great distances and different languages, laws and customs make it hard to know whether a buyer will pay. But they are also used in everyday domestic business.

Banks require every word, name, date and detail to be as specific and clear as possible. The slightest mistake can cause the bank to not pay, and to require a new Letter of Credit. For example, shipping a day late, or misspelling a name may cause the bank to not pay until a new Letter of Credit is created and accepted.

It’s also important to note that the bank pays the seller based strictly on the soundness of the LOC, with no regard for other factors such as the whereabouts of the actual goods, or the buyer’s satisfaction.

Advantages of an LOC for the seller include:

  • Reduced production risk in case the order is changed or canceled, and
  • Protection for the seller in case the buyer doesn't pay.

Advantages of an LOC for the buyer include:

  • The buyer is certain to receive the goods stipulated in the letter of credit, and
  • A letter of credit shows solvency for the buyer, and allows them to reduce or eliminate an initial payment. 

 

 

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