What is a Letter of Credit? | Definition, Working, Types, Pros vs Cons

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

  1. 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.
  2. It is a secure and reliable payment method for international trade, ensuring that both parties meet their contractual obligations.
  3. A letter of credit is a legal and binding agreement that requires strict compliance with its terms and conditions.
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How does it work?

  1. A letter of credit is issued by the beneficiary or any bank nominated by the beneficiary.
  2. The letter of credit can be transferable.
  3. If the letter of credit is transferable, another entity can be assigned, like a third parent or corporate with the right to draw.
  4. The collateral by the bank is in the form of cash or any other form of security before a letter of credit is issued.
  5. The service charge depends on the bank; it can also be a percentage of the letter of credit.
  6. 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.


Banking Quiz

Test your knowledge about topics related to banking

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Which of the following maybe the reason for returning a check?

2 / 10

What is a mutual fund?

3 / 10

What is a balance transfer in the context of credit cards?

4 / 10

What is a foreign exchange rate?

5 / 10

What do we call the banking oriented towards mass welfare and financial inclusion of the poor?

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What is the name of the type of account where you deposit money regularly and earn interest on the balance?

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What is the name of the type of investment where an individual lends money to a borrower and earns interest on the loan?

8 / 10

What is the main purpose of money transfer?

9 / 10

Which of the following is NOT among the functions of a central bank?

10 / 10

Which of the following is a type of loan provided by banks?

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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

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.   
  1. https://www.jstor.org/stable/1336141?seq=1
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