What is a letter of credit?

A letter of credit is a letter supplied by a bank as a guarantee that a payment will be made to another party on time and in full. It can be used to reassure a seller that their money is protected and can help an unknown buyer secure a sale, which might otherwise be denied.

Banks often charge for these letters with exact costs depending on the credit in question. This accounts for both the administrative costs of creating these letters and the risk taken by the bank in acting as the buyer’s guarantor in this manner. Letters of credit are often found in international trade as a means of protection, as well as for convenience.

How does a letter of credit work?

A letter of credit is not typically a fixed format – it is usually drawn up following some negotiation between the buying and selling parties. These letters can also come in a variety of different forms. For example, with a commercial letter of credit, the bank makes the payment in question directly to the seller. However, a standby letter of credit acts as more of a back-up, with the bank only committed to making the payment if the buyer defaults or does not meet their obligation in full.

Regular or valued customers at banks may also have access to what’s known as a revolving letter of credit, whereby they have a set amount of credit or a set number of transactions for which they can utilise letters of credit over a fixed period. This is particularly useful for companies that need to make regular transactions of this kind.

Individuals may be most familiar with letters of credit in the form of traveller’s cheques. These are promises by an individual’s bank to fulfil payment for cash withdrawals made at foreign banks. While they have become less common with the development of international banking and travel cards, these types of letters of credit may still be found in some exchange bureaus.

What is the use of a letter of credit?

A letter of credit can be useful for both buyers and sellers. For sellers, it provides a guarantee that payment will be made and can help mitigate any potential risks in a transaction – particularly when dealing with new buyers or buyers with an unclear or unstable financial history.

These letters can act almost as a reference for buyers, helping them build trust with new sellers and making other parties more likely to go ahead with a large transaction. Letters of credit can also be used as guarantees for a product or service delivery, giving a buyer a form of protection in any transaction by ensuring they’re able to recoup their expenses in the event of a failure to fulfil an obligation.

How do you get paid with a letter of credit?

Claiming your payment via a letter of credit will mostly be dependent on the type of letter of credit in question. Where a bank has supplied a standby letter of credit, the seller will typically be required to demonstrate fulfilment of their obligations as well as the failure of the buyer to make payment or to make full payment. This evidence should be submitted alongside the letter of credit that confirms the bank’s obligation to make this payment on the seller’s behalf. The bank may then choose to pursue the seller to recoup their costs.

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