Money is the medium of exchange in the form of coins or banknotes. It is used to pay for goods and services, buy things, pay debts, and so on.
Among buyers, sellers, loan borrowers, and the financial institution or bank, Letters of Credit and Lines of Credit play vital roles.
Key Takeaways
- A letter of credit is a financial instrument that guarantees payment to a seller on behalf of a buyer, subject to specific conditions and is often used in international trade.
- A line of credit is a flexible borrowing arrangement between a borrower and a financial institution, where the borrower can access funds up to a predetermined limit as needed.
- Letters of credit primarily facilitate trade by reducing transaction risk, while lines of credit provide ongoing access to funds for various purposes, such as managing cash flow or financing projects.
Letter of Credit vs Line of Credit
The difference between a letter of credit and a line of credit is that a Letter of credit is a document issued by the bank to the seller at the buyer’s request. At the same time, a line of credit is a financial instrument that helps the customer to borrow a maximum amount from the bank.
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A letter of credit is a financial document that a bank or financial institution issues to the sellers at the buyers’ request. Compared to the line of credit, it’s a very different instrument.
A line of credit is an instrument between the financial institution and the borrower; it fixes the maximum amount a person can borrow at any time.
Comparison Table
| Parameter of Comparison | Letter of Credit | Line of Credit |
|---|---|---|
| Usage | A letter of credit ensures that the payment is made promptly to the seller from the buyer’s end. | A line of credit is a financial instrument that supports the business or an individual with financial loans. |
| Flexibility | It’s rigid; it can be used only once to make payment to the seller from the buyer. | It is flexible; the customer can use the fixed amount to borrow at any time. |
| Fees and Rated | There is a fixed fee by the bank for a letter of credit, and there is no need to pay any interest. | The line of credit fee is fixed along with the borrower’s payments to pay interest only for borrowed funds. |
| Parties involved | In the entire context of the letter of credit, four entities are involved; buyer and seller and their respective two banks. | Only two parties are involved in the process, the borrower or customer and the financial institution or bank. |
| Geography | Letter of credit is mainly used in international trade or globally where buyers and sellers are from different countries. | Compared to the letter of credit, a line of credit is used locally where the customer and bank reside. |
What is Letter of Credit?
A letter of credit is a financial document or an instrument that the financial institution or the bank issues to the sellers at the buyer’s request.
A letter of credit is used to avoid credit risk. The purpose of the letter of credit is that the supplier is assured that the buyer will make payment after shipping the goods.
There are several types of letters of credit available for international trade. They are:
- A commercial letter of credit
- Revolving letter of credit
- Traveller’s letter of credit
- Confirmed letter of credit
A letter of credit is usually provided within two business days. It guarantees the payment from the buyer’s end if it fails, then from the bank.
What is Line of Credit?
A line of credit is an instrument between the financial institution and the customer or borrower; the maximum loan the customer can borrow by using the line of credit at any time up to a fixed amount decided by the financial institution for business or day-to-day life activity.
In the line of credit, only two parties will be involved customers and financial institutions. There are two types of lines of credit: secured lines of credit and unsecured lines of credit.
Most lines of credit are unsecured, where the borrower borrows the loan from the financial institution without promising collateral.
A line of credit is considered a revolving account where the financial institution allows the borrower to spend money, repay with interest, and again pay; it is a never-ending cycle where revolving.
Line of credit has different types of forms where each follows under the secured or unsecured line of credit. They are
- A personal line of credit
- Home equity line of credit
- Demand line of credit
- Securities – a backed line of credit
- A business line of credit
Main Differences Between Letter of Credit and Line of Credit
- The main difference between a letter of credit and a line of credit is that a Letter of credit is a document issued by the bank to the seller and issued upon the buyer’s request.
- A letter of credit is used to make payment to the seller by the buyer in an international trade transaction. At the same time, the customer uses the line of credit to borrow loans from the bank for business or personal reasons.
- https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=4155&context=lcp
- https://www.jstor.org/stable/838450
- https://repository.law.umich.edu/cgi/viewcontent.cgi?article=2776&context=mlr
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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.
