Below, we’ll discuss what a letter of credit is, how it works, and why it’s an important term to understand.
Definition and Example of a Letter of Credit
A letter of credit is a document outlining the agreed-upon terms and conditions of a transaction between buyer and seller. Banks act as a third-party intermediary for the sale and guarantee to make payment in the instance that the buyer defaults. There are different kinds of letters of credit that provide various types and levels of security for buyers and sellers.
Alternate name: Documentary letter of credit, documentary credit, credit letterAcronym: LC
For example, an exporter that gets a sale from an importer may request that the importer pay using a letter of credit. The importer would then work with a bank in its country to obtain a letter of credit. That bank would send the letter of credit to the exporter’s bank in the exporter’s country. The exporter would then ship the goods according to the terms stated in the letter of credit. After the banks approve that all conditions have been met, payment for the products is made.
How a Letter of Credit Works
Letters of credit can be very secure payment methods, and are often recommended in situations that have more risk including:
If payment terms are atypical If it’s a new customerIf the exporter is unable to verify the importer’s credit or the latter has bad credit
The importer benefits from the security provided by a letter of credit as well because in order for the exporter to get paid, it must provide documentation that the products have been shipped according to the agreed-upon terms.
Transaction Example
Here’s a step-by-step example of how a letter of credit transaction works:
Types of Letters of Credit
There are different types of letters of credit available. Here are a few of the common features you’ll find in these letters.
Sight or Term
This determines whether the seller gets paid as soon as they present all necessary documents—a sight letter of credit. Or at some other time as determined in the sales contract—a term, or “usance” letter of credit.
Revocable or Irrevocable
A revocable letter of credit allows the issuing bank to terminate or change the letter of credit at any point without notifying the seller. Most letters of credit are irrevocable, which means that the contract can’t be changed or terminated without the approval of all parties involved.
Confirmed or Unconfirmed
A confirmed letter of credit is issued when the buyer’s bank authorizes a bank in the seller’s location of operation to confirm the transaction as well. It’s additional security—in case the buyer’s bank defaults, the bank in the seller’s location will pay the seller. An unconfirmed letter of credit, meanwhile, doesn’t have a bank in the seller’s location acting as protection for the transaction.
