How a Letter of Credit Works

Protection for Payments

Young couple meeting with financial advisor
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A letter of credit is a document from a bank that guarantees payment. While there are several types of letters of credit, they are often used when buying and selling: if a buyer fails to pay a seller, the bank that issued a letter of credit will pay the seller (assuming all requirements are met).

Letters of credit can also protect buyers. If you pay somebody to provide a product or service – and they fail to deliver – the buyer might be able to get paid using a standby letter of credit.

That payment can serve as a penalty to the company that failed to perform, and it’s similar to a refund, allowing the buyer to pay somebody else to provide the product or service needed.

If you're familiar with escrow services, the concept is similar: banks act as "disinterested" third parties (they don't take anybody's side), and they release funds only after certain conditions are met. Letters of credit are common in international trade, but they are also used in domestic transactions (such as construction projects).

Key points:

  • A letter of credit provides protection for sellers (or buyers)
  • Banks issue letters of credit when a business “applies” for one and has the assets or credit to get approved
  • Letters of credit are complicated, and it’s easy to make an expensive mistake when using one

Example

A manufacturer gets an order from a new customer overseas. The manufacturer has no way of knowing if this customer can (or will) pay for the goods after they’re produced and shipped.

As a result, the purchase and sales agreement states that the manufacturer will get paid using a letter of credit as soon as shipment is made.

The buyer will need to apply for a letter of credit at a local bank. The buyer may need to have funds on hand at that bank or get approval for financing from the bank.

The bank will only send funds to the seller after the seller proves that the shipment was made. This is typically done by providing documents that show what was delivered, and where. In some ways, the buyer also enjoys protection under a letter of credit: some buyers would rather pay a bank with a big legal department than send the money directly to a seller.

If the buyer is especially concerned about getting ripped-off, there are options for the buyer (or somebody helping the buyer) to inspect the shipment before the payment is released.

The concept of a letter of credit can be complicated. The easiest way to get a handle on things is to see a visual step-by-step example.

The Money Behind a Letter of Credit

A bank promises to pay on behalf of a customer, but where does the money come from?

The bank will only issue a letter of credit if the bank is confident that the buyer will pay. Some buyers simply have to pay the bank up front, while other buyers use a line of credit with the bank (in other words, the bank lends money to the buyer).

Sellers must trust that the bank issuing the letter of credit is legitimate and that the bank will pay as agreed. If sellers have any doubts, they can use a "confirmed" letter of credit, which means that another (presumably more trustworthy) bank will guarantee payment. Sellers typically get letters of credit confirmed by banks in their home country.

When Does Payment Happen?

A beneficiary only gets paid after performing specific actions and meeting the requirements spelled out in a letter of credit.

For international trade, the seller may have to deliver merchandise to a shipyard in order to satisfy the requirements of the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that he made delivery, and the documents are forwarded to the bank. The letter of credit now must be paid – even (depending on how things are set up) if something happens to the merchandise. If a crane falls on the merchandise or the ship sinks, it's not necessarily the seller's problem.

Documents matter: to approve payment on a letter of credit, banks simply review documents proving that a seller performed any required actions. The bank is not concerned with the quality of goods or other items that may be important to the buyer and seller. That doesn't necessarily mean that sellers can send a shipment of junk: buyers can insist on an inspection certificate as part of the deal, which allows somebody to review the shipment and ensure that everything is acceptable.

For a “performance” transaction, a beneficiary (the buyer, or whoever will receive the payment) might have to prove that somebody failed to do something. For example, an organization might hire a contractor to complete a building project. If the project is not completed on time (and a standby letter of credit is used), the organization can show the bank that the contractor did not meet his obligations. As a result, the bank will pay the organization (so the organization can be compensated and hire somebody else to complete the project).

What Can Go Wrong?

Letters of credit make it possible to reduce risk while continuing to do business. They are important and helpful tools, but they only work when you get all of the details right. A minor mistake or delay can wipe out all of the benefits of a letter of credit.

If you rely on a letter of credit to receive payment, make sure you:

  • Carefully review all requirements for the letter of credit before moving forward with a deal
  • Understand all of the documents required
  • Will truly be able to get all of the documents required for the letter of credit
  • Understand the time limits associated with the letter of credit, and whether they are reasonable
  • Know how quickly your service providers (shippers, etc.) will produce documents for you
  • Can get the documents to the bank on time
  • Make all documents required by the letter of credit match the letter of credit application exactly (even typographical errors or common substitutions can cause problems)

International Trade

Importers and exporters regularly use letters of credit to protect themselves. Working with an overseas buyer can be risky because you don't really know who you're working with. A buyer may be honest and have good intentions, but business troubles or political unrest can delay payment (or put a buyer out of business).

In addition, communication is difficult across thousands of miles, different time zones, and different languages. A letter of credit spells out the details so that everybody's on the same page. Instead of assuming that things will work a certain way, everybody agrees on the process up front.

Letter of Credit Lingo

To better understand letters of credit, it may help to know the following:

  • Abbreviations for 'letter of credit' include L/C, LC, and LOC
  • Applicant - the buyer in a transaction
  • Beneficiary - the seller or ultimate recipient of funds
  • Issuing bank - the bank that promises to pay
  • Advising bank - helps the beneficiary use the letter of credit
  • Irrevocable - the letter of credit cannot be changed or canceled without permission from everybody involved

In addition to the terms above, you might hear about different types of letters of credit, and you might want to read more about the names of everybody involved.

Getting a Letter of Credit

To get a letter of credit, contact your bank. You'll most likely need to work with an international trade department or commercial division. Not every institution offers letters of credit, but small banks and credit unions can often refer you to somebody who is able to accommodate your needs.

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