Buying or selling something always carries risk, especially if you're not familiar with the organization you're dealing with. And even when you have trusted business partners, unforeseen circumstances can cause disruptions with real financial consequences. Fortunately, there are ways to manage your risk.
A letter of credit is a payment method that smoothes the way for international trade and a variety of other transactions. With a letter of credit, buyers and sellers can reduce their risk, ensure timely payment, and be more confident about reliable delivery of goods or services. Learning about different types of letters of credit can help you choose which one to use and understand what you’re working with.
Commercial Letter of Credit
This is a standard letter of credit that’s commonly used in international trade, and may also be referred to as a documentary credit or an import/export letter of credit. A bank acts as a neutral third party to release funds when all the conditions of the agreement have been met.
Standby Letter of Credit
This type of letter of credit is different: It provides payment if something fails to happen. Instead of enabling a transaction, a standby letter of credit provides compensation when something goes wrong. Standby letters of credit are generally similar to commercial letters of credit, but they are only payable when the payee (or “beneficiary”) can prove that they didn’t get what was promised in an agreement. Standby letters of credit are a form of insurance that ensures you’ll get paid, and they can also guarantee that services will be performed satisfactorily. They may be used with transferable letters of credit.
Confirmed (And Unconfirmed) Letters of Credit
When a letter of credit is confirmed, another bank (presumably one that the beneficiary trusts) guarantees that payment will be made. Exporters might not trust a bank that issues a letter of credit on behalf of a buyer. For example, if the exporter is not familiar with that bank, the seller may lack confidence that the payment will ever arrive. As a result, the exporter might require that a bank in their home country confirm the letter. If the issuing bank fails to pay—and the exporter can meet all of the requirements of the letter of credit—the confirming bank will have to pay the exporter (and attempt to collect from the issuing bank later).
Back-to-Back Letters of Credit
A back to back letter of credit allows intermediaries to connect buyers and sellers. This somewhat complicated strategy uses two letters of credit so that each party gets paid individually: An intermediary gets paid by the buyer, and a supplier gets paid by the intermediary. The final buyer and the intermediary might use a “master” letter of credit, and the intermediary and supplier use a letter of credit based on the master letter.
Revolving Letters of Credit
A revolving letter of credit is useful for multiple payments. If a buyer and seller expect to do business repeatedly, they may prefer not to get a new letter of credit for every transaction (or for every step in a series of transactions). This type of letter of credit allows businesses to use a single letter of credit for numerous transactions until the letter expires, and letters might be valid for three years or less.
Sight Letter of Credit
Payment under a sight letter of credit occurs as soon as the beneficiary submits acceptable documents to the appropriate bank. The bank has several days to review the documents and ensure that they meet the requirements in the letter of credit. If the documents are in good order, the bank must pay immediately.
Deferred Payment Letter of Credit
With this type of letter of credit, payment does not happen immediately after the documents are accepted. Some agreed-to period of time passes before the seller receives funds. A deferred payment letter of credit is naturally a better deal for buyers than for sellers, as it allows the buyer time to find fault with something the seller does. These letters may also be known as term or usance letters of credit.
Red Clause Letter of Credit
With a red clause, the beneficiary has access to cash up front. The buyer allows for an unsecured loan to be issued as part of the letter of credit, which is essentially an advance payment. The seller or beneficiary can then use the money to buy supplies, manufacture goods or complete work, and ship goods to the buyer.
Irrevocable Letter of Credit
An irrevocable letter of credit cannot be changed without authorization from all parties involved. Almost all letters of credit now are irrevocable, because revocable letters of credit simply do not provide the security that most beneficiaries want.
Frequently Asked Questions (FAQs)
What are the advantages of using a letter of credit?
Letters of credit put the risk of the transaction on a bank, as opposed to the buyer or seller. It provides a secure payment method that ensures the money will get where it needs to go. Letters of credit also provide the opportunity for parties to include safeguards, stipulations, or other quality control measures.
How do you get a letter of credit?
Many banks offer letters of credit, so you can get one by reaching out to a representative at your bank. Banks with dedicated international trade or commercial divisions will most likely offer letters of credit. If your bank doesn't offer letters of credit, it can probably point you toward an institution that will.
How much does a letter of credit cost?
The cost of a letter of credit depends on the bank that issues it. The fee is typically imposed as a percentage of the transaction amount. You might expect to pay a few percentage points, but the exact cost will depend on your credit history and the bank in question.
When might an exporter need to forgo a letter of credit?
If an importer is in a stronger bargaining position than the exporter, and the importer doesn't want to use a letter of credit, then the exporter may be left with no choice but to skip a letter of credit.