Letter of Credit
A letter of credit (also referred to as credit letter or c/l) is a letter from a bank that guarantees that a buyer will make a payment to the seller for the goods received in a timely manner through a bank. It is a conditional guarantee that a bank will pay a certain amount of money within a certain time frame to the seller or supplier. It has the opening date and the expiring date against stipulated documents.
A letter of credit is relevant where there is an exporter and an importer, and there needs to be a prepayment or a confirmation of payment in order for goods to be shipped.
The use of credit letters has become one of the key aspects of international trade since the nature of international dealings includes a lot of different factors. These factors are difficulty in knowing every single party personally and the different laws in different countries.
If the buyer is unable to pay due to the agreed contact through the letter of credit, the bank will cover the remaining price.
How a letter of credit works
If a buyer purchases a certain product that is highly expensive, he/she may need a letter of credit, guaranteeing to the bank that the payment will certainly be made. A bank then issues a letter of credit to prove that the seller of the product will be paid. In turn, a buyer needs to prove to the bank that he/she has enough capital to pay to the seller.
Generally, in order to issue a credit letter, banks require either cash or a pledge of securities.
Typically, the issuing bank pays the beneficiary because of the fact that a credit letter is a document that requires a fixed amount of money to be paid at a particular time.
Usually, it takes two business days in order for letters of credit to be provided.
Credit letters can also drastically boost one’s on-hand liquidity as well as the overall liquidity ratio. In case if one already has strong liquidity he/she can use it for earnings.
In addition the bank can require collateral from the buyer.
How much a letter of credit costs
Typically, banks charge a fee for a letter of credit. Usually a buyer can be charged anywhere from 0,75% to 1.5% of the transaction value. The cost of the credit letter can also depend on the size of the letter.
Example of a letter of credit
For instance, Mr. G, an Italian exporter, enters into a contract for the sale of pasta with Mr. K, a U.S. importer. In order to assure Mr. G of timely payment, Mr. K goes to his bank to open a letter of credit. The issuing bank sends the letter of credit to Mr G's bank, also known as the advising bank. After reviewing the terms, the advising bank confirms the receipt of the letter of credit to Mr. G. Mr G will then ship the goods, and send the shipment related documents to the advising bank, which further sends the documents to the issuing bank, which then verifies the documents and sends them to Mr. K. Mr K then makes the payment to Mr. G against the shipment of goods. As per their agreement, the letter of credit is valid till the payment is processed.
It is also important to note that the bank has the information about the buyer's creditworthiness and assets.
Types of letters of credit
There are different types of letters of credit that can be used by the importer and the exporter. They are:
Commercial Letter of Credit: The issuing bank makes payment to a beneficiary.
Revolving Letter of Credit: After the documentary exchange is completed a credit letter is immediately restored to its full amount.
Traveler's Letter of Credit: This type of c/l guarantees that issuing banks will honor drafts made in banks from different countries of the world.
Confirmed Letter of Credit: This c/l is made with a commitment of payment in addition to that of the buyer’s bank. This c/l is where a second bank other than a paying bank takes on the liability of getting the money from the paying bank.
Irrevocable Letter of Credit: It is a standard letter of credit. It is a credit letter that once established, cannot be amended, changed, or tampered with by either the buyer or the seller without mutual consent. Using this kind of credit letter, the buyer has confidence because once the buyer has the letter of credit, nobody, except for him/her and the seller can change the rules and conditions of this document.
Unconfirmed Letter of Credit: Only carries the obligation of the issuing bank (buyer’s bank) to honor all drawings (provided that the terms of the letter of credit have been met).
Transferable Letter of Credit: This type of l/c allows the buyer to transfer a certain amount of money to the seller even if the deal is way beyond the financial capabilities of a buyer. The transferable c/l then goes to the supplier’s bank.
Why use a letter of credit
Sellers generally tend to use letters of credit because they are sure that a bank is going to pay them against stipulated documents. It is a conditional guarantee that a bank will pay sellers under certain conditions.
