What Is a Letter of Credit and How Does It Work?

A letter of credit is a financial document issued by a bank that guarantees a buyer’s payment to a seller within a specified timeframe. It is used primarily in international trade transactions to mitigate risks, ensuring that all parties involved fulfil their contractu

al obligations. The issuing bank pays the seller directly upon the presentation of the required documents, which usually include shipping and title documents.

The effectiveness of a letter of credit lies in its ability to provide a level of certainty in international transactions. For the buyer, it ensures that the bank will only pay the seller once the agreed-upon goods or services are confirmed as delivered.

 How a Letter of Credit Works?

The process of a letter of credit begins when a buyer and seller agree to conduct a transaction using this method. The buyer then applies to their bank for a letter of credit, specifying the terms that the seller must fulfil. If the documents are in order, the seller’s bank forwards them to the buyer’s bank for payment. This letter of credit process ensures that the seller receives payment promptly upon fulfilling the terms.

When to Use a Letter of Credit?

Using a letter of credit is particularly beneficial in international trade, where the distance and differences in legal systems between the buyer and seller can create significant risks. It’s ideal for transactions where the reliability of the trading partner is uncertain or when the political or economic stability of the buyer’s country is questionable. A letter of credit provides a layer of security for both parties, ensuring that the seller receives payment as long as the terms of the credit are met, and the buyer receives the goods or services as agreed.

In scenarios where large transactions are involved, or in deals requiring detailed specifications for the goods, a letter of credit becomes essential. For businesses venturing into new international markets or dealing with new suppliers, a letter of credit serves as a reassurance that each party will uphold their end of the bargain, thus facilitating smoother and more confident trade dealings.

Also Read: What is Personal Loan Repayment and Types of Loan Repayment Methods?

How Much a Letter of Credit Costs? 

The cost of a letter of credit varies, typically ranging between 1% to 8% of the transaction value, depending on various factors like the creditworthiness of the parties involved, the total amount of the transaction, and the perceived risk. Banks charge this fee for providing the guarantee of payment and the administrative work involved in the letter of credit process. Additional costs can also arise from document handling, courier fees, and any amendments that might be required in the letter of credit.

Letter of Credit Types 

Letters of credit come in various forms, each tailored to specific trading needs and scenarios. Here are the letter of credit types:

Commercial Letter of Credit 

It is also known as a documentary credit and is commonly used in international trade. It guarantees payment to the seller upon the provision of documentary evidence that goods have been shipped. For example, a U.S. electronics retailer purchasing TVs from a manufacturer in Germany might use a commercial letter of credit to ensure payment upon shipment of the TVs.

Revolving Letter of Credit 

A revolving letter of credit is designed for ongoing transactions, allowing for multiple withdrawals up to a certain credit limit over a set period. This type is beneficial for businesses with regular, repeat transactions.

Traveller’s Letter of Credit 

A traveller’s letter of credit is used by individuals travelling abroad, ensuring they have access to funds. The issuing bank guarantees payment to foreign banks at certain intervals or when requested. For example, a student studying abroad might use a traveller’s letter of credit to secure living expenses from a home country bank.

Confirmed Letter of Credit 

Lastly, a confirmed letter of credit adds an extra layer of security, where a second bank, usually in the seller’s country, guarantees payment in addition to the buyer’s bank. For instance, a company importing oil from a volatile region might opt for a confirmed letter of credit to ensure payment despite potential economic uncertainties.

Example of a Letter of Credit 

An example of a letter of credit can illustrate its practical application, especially in a context relevant to India. Imagine an Indian textile manufacturer, “Mumbai Textiles”, agreeing to sell a bulk shipment of fabrics to a clothing retailer in France, “Paris Fashion House.”

Upon agreement, “Paris Fashion House” applies for a letter of credit at its bank in France. The bank then issues the letter of credit and forwards it to “Mumbai Textiles'” bank in India. This document states that the French bank will pay “Mumbai Textiles” the agreed amount upon receiving documentary proof that the fabrics have been shipped, typically including a bill of lading. Once “Mumbai Textiles” ships the fabrics and presents the required documents to its bank in India, the bank verifies them and forwards them to the French bank for payment. 

Letter of Credit Key Terms Glossary 

A letter of credit involves several key terms that are essential to understanding its functioning and the roles of the different parties involved.

Applicant: The applicant is the party that requests the letter of credit from a bank, typically the buyer in a transaction. For instance, a company importing goods from overseas will apply for a letter of credit at its bank, initiating the process to ensure payment upon delivery of the goods.

Beneficiary: The beneficiary is the recipient of the letter of credit, usually the seller in a trade transaction. For example, an exporter who ships goods to a foreign buyer will be the beneficiary, receiving payment upon presenting the required documents to the bank.

Issuing Bank: The issuing bank is the financial institution that issues the letter of credit at the request of the applicant. This bank is responsible for guaranteeing payment to the beneficiary when all terms of the letter of credit are met. It is the bank that evaluates the risk and creditworthiness of the applicant before issuing the letter.

Advising Bank: The advising bank acts as an intermediary, usually located in the beneficiary’s country, which informs the beneficiary of the terms and conditions of the letter of credit. This bank verifies the authenticity of the letter but does not guarantee payment. Its role is primarily to advise the beneficiary of the letter’s issuance.

Advantages and Disadvantages of a Letter of Credit

Here’s a comprehensive and detailed table outlining the advantages and disadvantages of using a letter of credit.

How to Apply for a Letter of Credit?

Applying for a letter of credit involves a series of steps that ensure the proper issuance and handling of this financial document.

Assess Need for a Letter of Credit: The buyer first determines the need for a letter of credit based on the transaction’s requirements.

Application to Buyer’s Bank: The buyer applies for a letter of credit at their bank, providing detailed information about the transaction.

Issuance of Letter of Credit: Once approved, the bank issues the letter of credit and sends it to the advising bank.

Advising Bank Verifies Letter of Credit: The advising bank verifies the authenticity of the letter of credit and informs the seller of its receipt and terms.

Bank Examination of Documents: The bank examines the documents for compliance with the letter of credit’s terms.

Completion of Transaction: With the receipt of goods and payment completion, the transaction under the letter of credit is concluded.

Also Read: Personal Loan Balance Transfer

Why Should My Business Use a Letter of Credit?

Using a letter of credit can be highly beneficial for your business, especially if you are engaged in international trade. It offers a high level of security for both the buyer and the seller, mitigating the risk of non-payment and non-receipt of goods. This financial tool is particularly crucial when dealing with new partners or conducting transactions in politically or economically unstable countries.

For instance, consider an Indian software services company, “Delhi Tech Solutions”, entering a contract with a European client. Given the substantial size of the contract and the geographical distance, “Delhi Tech Solutions” requests a letter of credit. This ensures that they will receive their payment after delivering the software project, while the European client is assured that their investment is protected against non-delivery.

Conclusion 

In conclusion, a letter of credit stands as an indispensable financial instrument in the realm of international trade, offering a secure bridge between buyers and sellers across the globe. It not only ensures that transactions are executed smoothly and securely but also fosters trust and confidence, which are key in expanding business horizons. For any business looking to mitigate risks in global trade, embracing the use of a letter of credit can be a strategic and prudent decision, paving the way for successful and reliable international partnerships.