A letter of credit is a written agreement between seller, buyer, and banks regarding terms and conditions of payment for goods or services. Letters of credit help to minimize risk for both the buyer and seller and are prevalent in international trade.
Below, we’ll discuss what a letter of credit is, how it works, and why it’s an important term to understand.
Definition and Example of a Letter of Credit
A letter of credit is a document outlining the agreed-upon terms and conditions of a transaction between buyer and seller. Banks act as a third-party intermediary for the sale and guarantee to make payment in the instance that the buyer defaults. There are different kinds of letters of credit that provide various types and levels of security for buyers and sellers.
- Alternate name: Documentary letter of credit, documentary credit, credit letter
- Acronym: LC
For example, an exporter that gets a sale from an importer may request that the importer pay using a letter of credit. The importer would then work with a bank in its country to obtain a letter of credit. That bank would send the letter of credit to the exporter’s bank in the exporter’s country. The exporter would then ship the goods according to the terms stated in the letter of credit. After the banks approve that all conditions have been met, payment for the products is made.
While letters of credit are one of the most secure payment options, they can be time-consuming and expensive. For instance, the buyer must pay a fee to its bank for the letter of credit.
How a Letter of Credit Works
Letters of credit can be very secure payment methods, and are often recommended in situations that have more risk including:
- If payment terms are atypical
- If it’s a new customer
- If the exporter is unable to verify the importer’s credit or the latter has bad credit
The importer benefits from the security provided by a letter of credit as well because in order for the exporter to get paid, it must provide documentation that the products have been shipped according to the agreed-upon terms.
Make sure you use trained professionals to prepare the documents for your letter of credit—the necessary documentation can be complicated and errors can lead to fees or late payment.
Here’s a step-by-step example of how a letter of credit transaction works:
- A sale made between a buyer and seller located in two different countries might use a letter of credit to ensure that delivery of the products and payment are carried out smoothly.
- The importer has its bank open a letter of credit to pay the exporter.
- The importer’s bank sends the letter of credit to the exporter’s bank, which in turn sends it to the exporter.
- The exporter ships the products and documentation is presented to the exporter’s bank.
- The bank then confirms that the exporter fulfilled its obligations in accordance with the terms agreed upon in the letter of credit.
- The exporter’s bank secures payment from the importer’s bank to give to the exporter.
- The importer pays its bank for the products, and the bank releases documentation so that the importer can claim the products and clear customs.
Letters of credit can be used for a single sale, or arranged to be ongoing and include multiple transactions.
Types of Letters of Credit
There are different types of letters of credit available. Here are a few of the common features you’ll find in these letters.
Sight or Term
This determines whether the seller gets paid as soon as they present all necessary documents—a sight letter of credit. Or at some other time as determined in the sales contract—a term, or “usance” letter of credit.
Revocable or Irrevocable
A revocable letter of credit allows the issuing bank to terminate or change the letter of credit at any point without notifying the seller. Most letters of credit are irrevocable, which means that the contract can’t be changed or terminated without the approval of all parties involved.
Confirmed or Unconfirmed
A confirmed letter of credit is issued when the buyer’s bank authorizes a bank in the seller’s location of operation to confirm the transaction as well. It’s additional security—in case the buyer’s bank defaults, the bank in the seller’s location will pay the seller. An unconfirmed letter of credit, meanwhile, doesn’t have a bank in the seller’s location acting as protection for the transaction.
- A letter of credit is a document from a bank that guarantees a transaction between a buyer and seller.
- This letter is often used in international trade. It’s a very secure payment option, but can be time-consuming and relatively expensive.
- The document outlines the agreed-upon terms and conditions of payment for a sale, with banks acting as third-party mediators and guaranteeing payment if the buyer defaults.
- There are various types and features of letters of credit available that offer different protections, from revocable and irrevocable to confirmed and unconfirmed.