A letter of credit, or "credit letter" 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 a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
Letter of credit is a payment instrument used majorly in international trade in which a bank provides monetary guarantee to enterprises which deal in import and export of goods. Letter of credit can be used for both import and export purposes. Enterprises doing businesses overseas have to deal with unknown suppliers and they require assurance of payment before performing any transaction. Therefore, letter of credit is important to provide payment assurance to the suppliers or exporters.
Whenever a letter of credit is issued, the products that are ordered by the buyer will be in possession of the bank. Until the buyer either makes the full payment or makes a payment to the bank for all the documents with an undertaking that the bank will take full responsibility, the possession of the products will not be released by the bank to the purchaser.
When the purchaser fails to make the payment due to a shortage of funds or any other reason, then the seller will place a demand to the bank asking the bank to make the payment. Then the bank will take a look at the demand placed by the seller or the beneficiary. If the demand matches with the details specified in the letter of credit, then the bank will meet the demand. If it does not match with the letter’s terms and conditions, then the bank will have a discussion with the seller and make appropriate payments.
When a purchaser requests a bank to issue and sign a letter of credit, then the buyer will need to provide a relevant collateral to the bank. The buyer will also be required to pay a particular fee for the documents and for the issuance of the letter to the bank. This fee will typically be a certain percentage of the amount that is taken care of by the letter of credit.
A letter of credit is a negotiable instrument. In this arrangement, when the buyer cannot pay the full outstanding amount, the bank that issues the letter of credit will need to make the payment to the seller. Sometimes, in certain cases, the seller will select a banker, and that banker will need to make the payment. If a letter of credit is transferable in nature, then the seller can choose another entity or party to make the payment.
Credit on sight
In this type of credit, entrepreneur can present a bill of exchange to lender with a sight letter and can take the funds instantly on the basis of letter of sight. Sight letter of credit is considered to be the most instant letter of credit that can be availed immediately.
Bill of exchange which is paid after agreed time period between the lender and the borrower is known to be time credit. Certain time period is involved in this type of credit. Letter of credit defining time credit allows borrower with some days to repay the amount, only after receiving the goods.
Revocable credit is a type of letter of credit in which the terms and conditions of this type of LC can be amended or cancelled by the issuing bank. It is not important for the issuing bank to tell beneficiaries regarding any change in the letter of credit.
Irrevocable Credit is a type of LC in which the terms and conditions cannot be amended or cancelled by the issuing bank. The bank has to obey the directions or commitments mentioned in the letter of credit.
Transferable credit, as the name suggests is a type of LC in which the beneficiary can transfer his/her rights to third parties. The terms and conditions may differ as per the trade and industry.
Typically, a letter of credit supports a seller or a beneficiary in an exchange agreement wherein the bank will make sure that the seller receives the amount either from the purchaser or from the issuing bank itself. This letter of credit arrangement also assists a purchaser in certain cases such as the purchaser making a payment to the seller for an order and the seller not delivering the order on time. In such a situation, with the help of a letter of credit, the purchaser will get paid with the money that was spent by him or her. Hence, this way, the purchaser will get a refund.
In a letter of credit facility, there are many financial terms that are commonly used. It is very important to know the meaning of these terms as it will help you in having a stress-free experience. You can also stay away from anyone trying to cheat you or trick you when you go for a letter of credit option.