The business between a buyer and a seller doesn’t involve only these two parts. When we talk about a big sum of money, a bank should naturally be involved. In fact, the task of guaranteeing a payment actually enters in the attributions of the bank. This is where the letter of credit comes into act.

People exchanging money

What is a letter of credit?

The letter of credit has to be sent by a bank, and it works as a guarantee for a seller that they should get the payment in time. Sometimes, it happens that the buyer doesn’t cover the entire amount of the payment. In these cases, the bank has to complete whatever remained of this payment.

Letters of credit have become quite common now, and are used a lot more often in international transactions. When someone buys something from a different country, more factors are involved. The laws are not the same everywhere. Also, judging from the distance, the payment doesn’t always happen quickly. Therefore, letters of credit have become necessary.

Why are letters of credit necessary?

Although it seems like they protect the seller, letters of credit are good for buyers as well. In case the seller doesn’t deliver the product or the service, such a letter can help the buyer. In fact, it serves as some sort of compensation for the disadvantaged part.

Letters of credit can allow a refund in case the service is not performed. Also, they allow the buyer to pay someone else to receive the same service of product. After issuing a letter of credit, the bank does not take anyone’s side. Also, it issues a payment only under strict conditions. The practice is common in international transactions, but can be used in local ones as well.

How does a letter of credit work?

To receive a letter of credit, one of the parts of the transaction needs to apply for one. However, the process is quite complicated, and a bank cannot grant it to anyone. Also, people need to be extremely careful, as they can often make mistakes which would cost them a lot.

Whenever a buyer makes an order for a product from a different country, they have to sign an agreement. The buyer cannot verify the seller’s policies, so they agree to make the payment through a letter of credit. This means that, once the buyer receives the product, the seller will get the letter and the payment can be made.

Person holding a credit card in front of a laptop

For this, the buyer needs to apply for the letter of credit. This should happen at a bank where they have some available funds. Then, to receive the money, the seller must prove that they performed the delivery. In some cases, the buyer can ask the bank to investigate this delivery. If everything is alright, then the bank can release the payment.

Where does the money come from?

One essential condition for the bank to issue such a letter is certainty regarding the client. In other words, a bank will only agree to a letter of credit if it’s convinced you can pay. There are two alternatives in this case.

One requires the buyer to pay the bank the exact amount of money owed to the seller. In the second alternative, the bank can lend the buyer the money. However, they have to sign a credit agreement. For this, they have to make sure the bank is serious and will really send the payment.

Sellers can also make sure they receive the money. If they have doubts regarding the bank, they can ask for a confirmation, or a second letter of credit. This can come from a second bank they trust which guarantees the legibility of the first bank. Most of the time, this guaranteeing bank is one coming from the home country of the seller.

Coins arranged on a table

Possible drawbacks of a letter of credit

This is one effective way to make sure you get a payment or product. However, the issue is extremely complex. If you omit even one single detail, then this tool might bring a huge number of consequences. There are some things which you should keep in mind when making such a decision.

Before striking a deal for a letter of credit, make sure you carefully read everything it requires. Also, get informed on all the papers and documents you have to provide. If it’s something you don’t agree with, do not go on. Also, make sure you can provide all the papers for the bank before signing.

Letters of credit come with some limits related to time. These are thoroughly stated before signing the deal, so read them carefully. If it’s something you don’t agree with, state your disapproval and abandon the idea. Also, make the delivery services or other providers of documents give your papers on time. Any delay might cost you.

In the end, make sure you write the application accordingly. Also, verify the documents to correspond with the bank’s requests. Everything needs to be identical, as even a small typo might strike down the deal.

Different types of letters of credit

Letters of credit are of various kinds, and it depends on the situation which one is suitable for you. One type of the commercial letter, where the bank is the one that pays the seller when need be. A standby letter is a different type, where the bank intervenes only if the buyer is not able to make the payment himself.

Through a revolving letter, the buyer can make some draws from the sum over a clearly specified period of time. A traveler’s letter is when a bank engages to send a part of the sum to a series of banks from the seller’s countries. Other types include the confirming letter, where the bank receives a guarantee from a different bank.

Conclusion

A letter of credit is a good way to make sure an international transaction goes as planned. If you are selling something, this assures you that you get the money. If you are buying something, you don’t risk losing money in case you don’t receive the product. However, pay a lot of attention before signing up for a letter of credit, as it is risky if you don’t respect all the requirements.

Credit card placed next to a laptop's keyboard

Image sources: 1, 2, 3, 4, 5.