A letter of credit is a document called a credit letter given by a bank or financial services. A letter of credit guarantees a seller receives the agreed payment from the buyer. The bank pays the stipulated amount in full or the remaining portion to the seller if the buyer cannot pay the amount.
International transactions can be carried out using a letter of credit. Many factors like distance, respective country laws, and unknown trade parties affect business; a letter of credit is popular as it isn’t affected by these factors. Banks charge 0.25 to 2 % depending on the type of letter of credit margin, customer credit rating, tenure, and other such factors.
Key Takeaways
- A letter of credit is a financial document issued by a bank on behalf of its client, guaranteeing payment to a seller upon delivery of goods or services.
- It is a secure and reliable payment method for international trade, ensuring that both parties meet their contractual obligations.
- A letter of credit is a legal and binding agreement that requires strict compliance with its terms and conditions.
How does it work?
- A letter of credit is issued by the beneficiary or any bank nominated by the beneficiary.
- The letter of credit can be transferable.
- If the letter of credit is transferable, another entity can be assigned, like a third parent or corporate with the right to draw.
- The collateral by the bank is in the form of cash or any other form of security before a letter of credit is issued.
- The service charge depends on the bank; it can also be a percentage of the letter of credit.
- The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits monitor letters of credit used for international transactions.
Types of Letters of Credit
Commercial Letter of Credit
The bank issues this letter of credit for direct payment to the beneficiary.
A standby letter of credit
This letter of credit is issued by the bank only when the account holder cannot clear beneficiary dues.
Revolving Letter of Credit
This letter of credit is issued by the bank, which allows a customer to make any number of draws within a certain limit during a specific period.
Traveller’s Letter of Credit
This letter of credit is for travellers planning to go abroad.
Confirmed Letter of Credit
This letter of credit is given by the second bank, confirming the payment. The second bank is the seller’s bank. The confirming bank ensures that the letter of credit is honoured in case the issuing bank defaults on payment. This letter is issued for international transactions.
Advantages and Disadvantages of Letter of Credit
| Advantages | Disadvantages |
| A letter of credit is useful for making transactions with unknown partners or establishing new trades. | The letter of credit is very costly; banks charge fees for services, and additional features cost extra. |
| The letter of credit offers safety for the seller or exporter in case the buyer or importer goes bankrupt. The bank pays as the issuing banks act as guarantors for the importer. | The letter of credit is based on quantity and not quality. The bank may end in dispute if the exporter’s product quality differs from the sample. |
| A letter of credit allows both trading parties to dictate clauses in the letter of credit. It can also be customized for every transaction. | The letter of credit comes with an expiry date, and the exporter has a time frame limitation. |
| A credit letter also helps resolve disputes by allowing the exporter to withdraw funds. |
Last Updated : 11 June, 2023
I’ve put so much effort writing this blog post to provide value to you. It’ll be very helpful for me, if you consider sharing it on social media or with your friends/family. SHARING IS ♥️
Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
A very well-structured and balanced article. The inclusion of advantages, disadvantages, and references adds to its credibility.
The article has certainly increased my understanding of letters of credit.
Absolutely, this is a valuable resource on the topic of letters of credit.
This is a very informative article. I didn’t know letters of credit could be so flexible and interesting.
I agree, it’s a great overview of the main aspects and types of letters of credit.
I found the article a bit too long and complex to understand. It would have been helpful to have more practical examples.
I also think that real-life examples would’ve helped in understanding the theoretical concepts better.
The article provides a detailed understanding of letters of credit, but the language is too formal and complex.
Some of the terminology used in the article could be explained better.
I agree, simplifying the language would make it more accessible to a wider audience.
The in-depth explanation of the types of letters of credit and how they work was very enlightening.
I appreciated the clarity in which the various types of letters of credit were presented.
Yes, the detailed descriptions helped in understanding the nuances of these financial instruments.
This article provides a comprehensive overview of letters of credit. The advantages and disadvantages section is particularly enlightening.
Yes, the advantages and disadvantages analysis is very insightful.
I also found it very informative and useful.
The article’s insights could be complemented by additional graphical representations or diagrams for better clarity.
Visual aids would indeed enhance the understanding of such complex financial mechanisms.
I don’t agree with the advantages listed here. Costs are too high for the letter of credit to be considered useful.
I respectfully disagree. The benefits are substantial when considering safety and risk management.
The author’s analysis of the benefits and drawbacks of letters of credit was thorough and thought-provoking.
Agreed. The article raises critical points for consideration in assessing the practicality of letters of credit.
The use of real-world examples would have further enriched the article’s content and practical applicability.
I agree. Real-life examples would make the content more relatable and easier to comprehend.