A letter of credit is a written document from a bank guaranteeing the seller of a product or service will be paid as long as the goods or services are provided, as specified. Letters of credit are widely used as risk management tools in international trade, where they let sellers ship goods with confidence and allow buyers to obtain goods without making advance payments. A financial advisor can help you manage risk in your own financial affairs and help you create a long-term plan to maximize the growth of your wealth.
How Letters of Credit Work
A letter of credit is a legal document obligating a bank to pay a preset sum when specific conditions are met. For instance, a seller based in America can request a letter of credit before shipping goods to a small, new or unfamiliar buyer in another country so that they know they will get paid. This helps keep budgets in line and business scams down.
With the letter of credit in hand, the seller knows that if it ships the goods as required and this is properly documented, it will receive payment. Payment will be issued even if the foreign buyer decides it doesn’t want the goods, goes bankrupt or is otherwise unwilling or unable to pay.
Four parties are named in a typical letter of credit:
- Issuing bank
- Advising bank
The applicant is the buyer who requests a letter of credit from their own bank. This bank is the issuing bank that will be responsible for making payments to the seller, who is known as the beneficiary. The advising bank, also called the confirming bank, will verify the documents from the seller attesting that the goods have been delivered to the buyer as specified and notify the issuing bank to pay the seller.
Terms of a Letter of Credit
The terms in a letter of credit will narrowly specify product quantity, type, quality and the date it is received. These terms must be conformed to exactly before the issuing bank will release payment. A number of documents may be necessary to demonstrate conformance, including an invoice, bill of lading, packing list, inspection certificate and certificate of insurance.
A letter of credit may also have a sizable number of additional terms and conditions. For instance, a letter of credit may be revocable by either party under certain conditions or it may be irrevocable. It may be transferable so that it can be sold to another party that will then be able to collect the payment.
Letter of Credit Benefits
Letters of credit help smooth problems raised by legal, regulatory and cultural differences as well as the long distances and lengthy times involved when trading goods between countries and continents. An exporter can make sales with confidence, knowing that it will be paid, even when the buyer is on the other side of the world, new, small or has shaky or unproven credit.
From the buyers’ perspective, letters of credit let them obtain products that sellers might otherwise be reluctant to supply without advance payment. They can reduce the buyer’s financing costs as well as the risk that a foreign seller will fail to ship products on time and in good condition.
Letters of credit are considered highly secure. Sellers can be confident they’ll be paid if they perform as required. Buyers are relieved of the risk of paying for goods that aren’t delivered because of the extensive proof of delivery needed for sellers to receive payment.
Letter of Credit Drawbacks
The advantages of letters of credit come with costs and limitations. Fees the participating banks charge for setting up and paying the letter of credit can total 1% or so of the total value of the sale, which reduces profit margins.
Terms of a letter of credit can be complex and it may take significant time to negotiate and complete the necessary paperwork for a deal to proceed. In the end, the seller must comply with the terms precisely when presenting documents confirming the shipment or face difficulty in collecting from the issuing bank.
The Bottom Line
Letters of credit are useful in international trade for assuring sellers of payment and helping buyers overcome challenges of distance and unfamiliarity in order to obtain goods. A bank that issues a letter of credit at the request of a buyer will pay the sale price to the seller when presented with documents confirming that the required quality and quantity of goods shipment has been delivered in the preset time frame. Letters of credit add to the cost and complexity of international trade but are highly secure and widely employed.
Tips for Financial Planning
- A financial advisor can help you prepare letters of credit and other tools to make conducting business easier and more profitable. If you don’t have a financial advisor, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Like a letter of credit, a bank guarantee is a document that can help companies feel confident about doing business with each other. Bank guarantees and letters of credit operate differently, however. A bank guarantee is activated when one party to an agreement fails to perform a contractual obligation, such as failing to make an equipment leasing payment. In that case, the guaranteeing bank would pay the rental amount.
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