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What Is a Letter of Credit?

A letter of credit is a guarantee from a bank against risk for a seller that their buyer will pay, and is common in sales agreements that include shipping to or from overseas. The guarantee is that payment will be the correct amount and will be paid within a set time frame. In return for providing the letter of credit, banks or lenders usually will require certain documents of proof like shipping confirmation.

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what is a letter of credit - satisfied business owner with a letter of credit

As importing and exporting intrinsically comes with the risk of non-payment or non-delivery, depending which end of the chain you’re on, it’s useful for companies involved to have some sort of security in place, particularly as resolving such disputes over distance can be tricky.

When can a letter of credit be used?

If your company frequently trades overseas, you’ve probably come across a letter of credit before, but did you also know that some funders for trade finance and import/export finance might require one from you as well?

While using a funder for trade finance or import/export finance to improve your company’s cash flow, there’s essentially another party involved who will need a guarantee that the money they are providing for the financing agreement will be repaid.

Are there costs involved with getting a letter of credit?

Because the bank or lender is giving security that money will be paid or received, they will charge a fee which is usually a percentage of the amount covered by the letter of credit.

For example, if your bank or lender charges 1% for a letter of credit and the amount the letter is covering is £100,000, you’ll pay £1,000 in fees.

Types of letter of credit

The most commonly used types are:

  • Irrevocable
    Unless everyone in the process agrees, an irrevocable letter of credit cannot be cancelled or changed, which means it provides a little more security than a revocable one.
  • Revocable
    The letter of credit can be changed or cancelled at any time by the issuer.
  • Confirmed
    Once the buyer’s bank has issued the letter of credit, the seller can opt to have it confirmed by a bank of their choosing to ensure that it’s legitimate. This also provides more security than leaving it unconfirmed.
  • Unconfirmed
    As the name might suggest, this is a letter of credit that has been issued but not confirmed by a second bank.
  • Transferable
    If there are intermediaries working in the transaction between buyer and seller, the letter of credit can be passed between parties on the receiving end of payment.

Combinations of the above five types are also available, like a confirmed and revocable. In addition to the types already listed, letters of credit can also be:

  • Standby
    If the seller doesn’t expect to have to draw on a letter of credit but would like security just in case, they can have this in the form of a standby letter of credit from the buyer.
  • Revolving
    If the buyer and seller expect to have a longer lasting relationship and multiple transactions, then a revolving letter of credit is useful for covering more than one transaction.
  • Back-to-back
    If a transferable letter of credit isn’t suitable for the process between buyer and seller but there are still intermediaries involved, a back-to-back letter of credit can be used in its place.

Benefits of a letter of credit for sellers

As a seller, having a letter of credit means a guarantee that you’ll receive the money due to you on time and in full. You have a sense of security surrounding the payment, provided that all terms and conditions are met, as all the risk is transferred to the bank or funder providing the letter instead.

They’re also useful if you’re looking to secure financing. Some trade finance providers will ask for one before finalising the facility. Once you have it all in place, you could be in a better position to purchase materials and supplies to fulfill orders.

Benefits of a letter of credit for buyers

Buyers with a letter of credit can guarantee that they’ll receive the goods they’re paying for and so the risk of being out of pocket with nothing to show for it is reduced.

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