What is a Letter of Credit (LC)? What Types of LCs Are There?

A letter of credit is an important type of financial instrument commonly used in international transactions or in cases when both buyers and sellers need to guarantee that payment will go through. They’re excellent tools when buyers and sellers don’t know each other personally or when international distances can get in the way of commercial success. But letters of credit are somewhat complex if you’ve never used them before. Furthermore, there are multiple types of letters of credit that may be used for different situations or circumstances. In this guide, we’ll break down exactly what letters of credit are and what types of LCs you might find during your business interactions . Let’s get started!

What is a Letter of Credit, Anyway?

A letter of credit is, essentially, an official letter from a bank that guarantees payment to a certain seller will always be received on time and for the right amount. Think of it as a kind of payment guarantee – since letters of credit are backed by banks, people trust them since most banks are generally regarded as trustworthy financial institutions. However, letters of credit serve an additional purpose. If a buyer can’t make the correct payment (either on time or in the right amount) to a given seller, the bank takes on the responsibility for making the payment. Letters of credit put banks on the hook for paying either the full or remaining amount for a given purchase. Traditionally, letters of credit are used as payment guarantees for large-scale or long-distance payments, particularly when it comes to international trade. You can get letters of credit from most major banks and credit unions.

How Do Letters of Credit Work?

A letter of credit is a type of negotiable instrument. This just means that letters of credit can be modified or written to better serve their unique purposes. Banks issue letters of credit to both buyers and/or sellers. When a bank issues a letter of credit to a seller, it guarantees any stated funds. The letter can be transferred from one party to the other. For instance, the seller of a transaction can withdraw funds from the letter if the buyer doesn’t pay up. Or the seller can assign the same benefits of a letter of credit to someone else depending on circumstances. The bank, meanwhile, makes money by charging a small fee to the buyer in a given transaction. This fee is usually applied as a percentage of the total letter of credit amount. For example, if a letter of credit is issued to guarantee the transfer of funds for the purchase of a $100,000 car across international borders, the bank may charge a $5000 fee to the car buyer, or a 5% fee based on the total price of the car purchase. Furthermore, banks will often demand a deposit or collateral from the buyer to make sure that they are not taken advantage of. This is especially common when it comes to international purchases.

Where Does the Money Behind a Letter of Credit Come From?

Now we’ve got the basics: letters of credit are negotiable financial instruments that cause banks to promise to pay on behalf of a buyer or seller. But where does the bank get that money in the first place? It usually comes from the bank itself. Banks treat letters of credit similarly to loans in that there is some risk that they will be taken advantage of by one party or the other. But they make up for this risk by charging fees or requesting collateral for each letter of credit. Since most people honor letters of credit, the bank ends up making a profit in the long run. The exact funding process will differ from bank to bank. For instance, some banks will require buyers to pay the bank initially before issuing a letter of credit. They may alternatively request that buyers open up lines of credit – this acts the same as taking a loan from the bank overall.

When Does Payment Occur?

Payment associated with letters of credit will be deposited at different times depending on the purchase circumstances. For letters of credit concerning international trade, sellers must usually deliver merchandise to shipyards or other shipping centers in order to satisfy their letters’ requirements. Since letters of credit are negotiable, the exact delivery area and time can vary significantly from letter to letter. After the merchandise is delivered to the appropriate place at the appropriate time, sellers will receive documentation that can prove they made a delivery. Once the documents are forwarded to the bank, any funding deposits will be made to applicable bank accounts. Note that banks are not typically concerned with the actual quality of goods (such as whether they are exactly as agreed or if they come in a damaged condition). All banks care about is whether items are delivered to the correct place. Banks will review basic documents to prove that a seller did the bare minimum before releasing payment. However, buyers can sometimes insist on banks adding an “inspection certificate” to a letter of credit. This requires an inspection as part of the deal to make sure that they aren’t getting junk for their time.

The Letter of Credit Process in Detail

Let’s break down how letters of credit are used step-by-step:

• To start, the exporter or seller agrees to provide goods or services to the buyer or applicant. They are usually in another country from the seller.
• The seller contacts a bank in the same country as the buyer. The bank will draw up a letter of credit that states what’s expected of both the buyer and the seller, including shipping details, payment details, and more.
• The bank will then issue the letter of credit. During this time, they may also request a fee from the buyer and perform a background check to make sure that both ends of the bargain are upheld.
• After both parties review the letter of credit, shipping can commence.
• Upon the terms of the agreement being completed (i.e. goods are delivered on time and at the agreed place), the bank will release funds. The bank holds funds in a type of escrow account to prevent buyers or sellers from taking advantage of them.

Types of Letters of Credit

There are a few different types of letters of credit you might encounter:

• A commercial letter of credit is the most common type available. It’s a direct payment method where the bank issuing the letter of credit makes payments to the seller or beneficiary.
• A standby letter of credit is similar to a commercial line of credit. The only difference is that banks only pay the seller when the holder can’t do so directly (whether because of currency differences or other factors).
• A revolving letter of credit is used to let sellers make several different funding withdrawals from a certain time period. This may be used with repeated shipments or purchases within a set timeframe.
• A traveler’s letter of credit is perfect for international businesspeople. It’s a letter that guarantees that certain issuing banks will honor different withdrawals or drafts made at participating foreign banks.
• A confirmed letter of credit is used between banks. It involves a second bank from the original issuing bank that guarantees payment in the event that the issuing bank defaults or whatever reason. It’s commonly used for international transactions since international banks don’t always trust one another.

Who Benefits From Letters of Credit?

Letters of credit are primarily used to protect buyers who want to make sure that they get paid on time and in the correct amount. Remember, all letters of credit put banks (or letter writers) on the hook for any missed or incomplete payments. Thus, buyers can feel a little more secure putting down big money, especially for international purchases. However, letters of credit are also important for seller protection. For example, if a buyer doesn’t pay a seller for an item or service, a letter of credit can also force a bank to pay the seller the correct amount. In this way, both parties in a given transaction come away feeling more secure and have more peace of mind.

Summary

All in all, letters of credit are important financial instruments you can use to guarantee transactions and make international commerce much more secure and reliable. It’s also important to understand these instruments since you’ll eventually encounter them if you ever do business with international business owners or banks. Fortunately, Seek Capital has even more financial advice and guides in case you need assistance when doing international business. Contact us today for business loans and don’t hesitate to check out our other business best practices and guides ! Sources https://www.investopedia.com/terms/l/letterofcredit.asp https://www.wellsfargo.com/mortgage/manage-account/escrow/ https://definitions.uslegal.com/t/travelers-letter-of-credit/#:~:text=Traveler's%20letter%20of%20credit%20refers,favor%20the%20credit%20is%20drawn .