Letter of Credit Definition
What are letters of credit? We can define letters of credit as documents issued by a bank that guarantee payment to a seller on behalf of a buyer. Letters of credit essentially eliminate the seller’s risk of non-payment by substituting the bank’s credit for the buyer’s credit.
A letter of credit specifies the payment amount and the time period in which the letter of credit is good. Once a letter of credit has been issued and the terms and conditions of the contract have been met, the bank must make the payment to the seller on behalf of the buyer. Letters of credit are often used in international transactions, where the buyers and sellers may be unsure of each other’s credit or reliability.
Letter of Credit Explanation
Letters of credit are often issued in international transactions and typically involve four parties: the importer, the importer’s bank, the exporter, and the exporter’s bank. Importer’s and exporter’s banks, in this case, simply refer to a commercial bank domiciled in the importer’s country and a commercial bank domiciled in the exporter’s country. The importer may be unsure of the reliability of the exporter and the quality of the exporter’s goods; the exporter may be unsure of the importer’s creditworthiness and ability to make payment. By using banks as intermediaries, all of these concerns are alleviated.
Once an importer and an exporter have agreed to a trade transaction, but before money or goods have changed hands, the importer will go to the importer’s bank and, for a fee, apply for a letter of credit. The importer’s bank then issues a letter of credit for a set amount and a set time period and guarantees payment to the exporter as long as the terms and conditions of the contract are met.
The importer’s bank then sends this letter of credit to the exporter’s bank, saying they’ll guarantee payment once the exporter’s bank provides documents proving the goods have been shipment. Once the importer’s bank sees these documents, the importer’s bank makes a full payment to the exporter’s bank. The exporter can then collect its money from the exporter’s bank and the importer will receive its purchased goods.
Types of Letters of Credit
There are several types of letters of credit, though the most common type is a confirmed irrevocable letter of credit. This type of letter of credit cannot be changed or altered in any way without the consent of all relevant parties, and the issuing bank is obligated to make the payment to the seller.
Other types of letters of credit include revocable letters of credit, which may be altered by the issuing bank; revolving letters of credit, which are automatically renewed periodically to allow for recurring transactions between the same buyer and seller; and traveler’s letters of credit, which are issued on behalf of traveling customers and which list several banks that will honor the contract.