How a Letter of Credit Works

A bank’s letter of credit is a document that ensures payment. There are various letters of credit varieties, and they can offer security while purchasing and offering services or goods.

Protection for the seller: If a buyer defaults on a letter of credit, the issuing bank is obligated to pay the seller, provided that the seller complies with all of the letter’s conditions. When the buyer and seller are in different nations, this offers security.

Buyer protection: Letters of credit can also provide buyer protection. You might be able to use a standby letter of credit to get reimbursed if you hire someone to supply a good or service but they don’t show up. It’s possible for the payment to be a company that was unable to perform, and it’s similar to a refund. With the money you receive, you can pay somebody else to provide the product or service needed.

The idea is similar to escrow services in that banks take on the role of neutral third parties. Banks only distribute money after a number of requirements have been satisfied. They don’t take sides. In addition to being useful for domestic operations like construction projects, letters of credit are frequently used in international trade.

Key points:

  • Sellers are protected by a letter of credit (or buyers).
  • When a company “applies” for a letter of credit and has the necessary assets or credit to be authorized, the bank issues the letter of credit.
  • Because letters of credit are intricate, employing one might lead to costly mistakes.


  • An overseas new client places an order with a manufacturer. After creating and shipping the goods, the producer has no means of knowing if this consumer can (or will) pay for them.
  • The seller utilizes a contract that demands the buyer pay with a letter of credit as soon as shipping is done in order to manage risk.
  • The buyer must submit an application for a letter of credit at a bank in their own nation in order to proceed. The buyer might be required to have funds on hand at that bank or obtain bank permission for financing.
  • Only once the seller provides proof that the shipping took place will the bank disburse money to the seller. The seller often offers documents demonstrating how to do the goods were shipped (with details like the exact dates, destination, and contents). In some ways, the buyer also enjoys protection under a letter of credit: Buyers might prefer to pay a bank with a big legal department rather than send the money directly to an unknown seller.
  • If the buyer is concerned about a dishonest seller, there are additional options available for the buyer’s protection. For example, somebody can inspect the shipment before the payment is released.

The Money Behind a Letter of Credit

Where does the money come from when a bank says it will make a payment on a customer’s behalf?

If the bank has confidence in the buyer’s ability to pay, it will only provide a letter of credit. Some customers are required to pay the bank in advance or consent to the bank freezing their funds. Others might borrow money from the bank by using a line of credit they have with them.

Sellers must have faith that the bank issuing the letter of credit is reliable and will make the agreed-upon payments. A “confirmed” letter of credit, which signifies that another (often more reliable) bank will guarantee payment, can be used by sellers if they have any concerns.

When Does Payment Happen?

For international trade, To fulfill the conditions of the letter of credit in international trade, the seller can be required to deliver goods to a shipyard. As soon as the product is delivered, the seller receives documentation attesting to the delivery, which is then sent to the bank. In some circumstances, the bank is required to make the payment even if something bad happens to the shipment merely by loading the shipment onto a ship. It’s not always the seller’s problem if a crane falls on the goods or if the ship sinks.

Documents matter: Banks just need to check documents demonstrating that a seller took any necessary procedures in order to approve payment on a letter of credit. The quality of the products or other potentially significant items is unimportant to the bank to the buyer and seller. That doesn’t necessarily mean that sellers can send a shipment of junk. Buyers can insist on an inspection certificate as part of the deal, which allows somebody to review the shipment and ensure that everything is acceptable.

For a “performance” transaction, A beneficiary (the buyer or the person who will get the payment) may need to demonstrate that someone failed to fulfill their obligation in a “performance” transaction. For instance, a city might employ a contractor to finish a construction project. The city may be able to convince the bank that the contractor did not fulfill his responsibilities if the project is not finished on schedule (and a standby letter of credit is used). So, the bank is obligated to reimburse the city. With that money, the city is made whole and it is made simpler to find a different contractor to finish the job.

What Can Go Wrong?

Using letters of credit, it is feasible to lower risk while conducting business as usual. They are valuable and practical instruments, but they only function well when all the details are correct. The advantages of a letter of credit can be completely negated by a small error or delay.

If your method of payment is a letter of credit, be sure to:

  • Before approving any transaction, carefully study all letters of credit conditions.
  • Recognize each of the necessary paperwork. Ask your bank for clarification if you are unsure of anything.
  • will be able to acquire each and every document required for the letter of credit.
  • Recognize the deadlines attached to the letter of credit and determine whether they are fair Know how quickly your service providers (shippers, etc.) will produce documents for you
  • Can get the documents to the bank on time
  • Verify all documents required by the letter of credit and match them to the letter of credit application exactly. Even typographical errors or common substitutions can cause problems

International Trade

Letters of credit are frequently used by exporters and importers as a kind of insurance. Because you don’t really know who you’re working with when working with an international buyer, it can be problematic.

Even if a buyer is trustworthy and has the best of intentions, financial difficulties or political turmoil might cause payment delays or even force a buyer out of business.

Additionally, communication is challenging when taking place across long distances, in several time zones, and in various languages. A letter of credit outlines the specifics so that everyone is aware of them. Everyone comes to an agreement on the procedure up front rather than presuming that things will proceed in a specific way.

Letter of Credit Lingo

Understanding the terminologies aids in comprehending letters of credit.

Applicant: The party making the letter of credit request. This is who or what will give the money to the beneficiary. Frequently, but not usually, the applicant is an importer or buyer who uses the letter of credit to complete a transaction.

Beneficiary: The recipient of the payment. Typically, a seller or exporter is the one who has asked the application to utilize a letter of credit (because the beneficiary wants more security).

Issuing Bank: The financial institution that, at the applicant’s request, issues the letter of credit. Typically, it is a bank where the applicant already conducts business (in their country of residence, where they have an account or a line of credit).

Negotiating bank: Bank engaged in negotiations with the beneficiary. This bank is frequently found in the beneficiary’s place of origin, and it might even be one where the beneficiary already has an account. The negotiating bank receives documentation from the beneficiary and serves as a point of contact between the beneficiary and the other banks involved.

Confirming bank: A bank that “guarantees” payment to the beneficiary as long as the terms of the letter of credit are met is known as a “confirming bank.” Payment is already guaranteed by the issuing bank, but the beneficiary may desire a guarantee from a bank in their country of residence (with which they are more familiar). This might be the same bank as the one doing the negotiations.

Advising bank: The bank that advises the recipient of the letter of credit is the issuing bank and notifies the beneficiary that the letter is available. This bank is also known as the notifying bank and may be the same bank as the negotiating bank and the confirming bank.

Intermediary: A business that serves as an intermediary between buyers and sellers, occasionally using letters of credit to speed up transactions. Frequently, intermediaries would employ successive letters of credit (or transferable letters of credit).

Freight forwarder: A company that aids in international shipment is a freight forwarder. The documentation that exporters must submit in order to be compensated is frequently provided by freight forwarders.

Shipper: The business that moves products from one location to another.

Legal counsel: A business that gives applicants and recipients guidance on using letters of credit. Get assistance from a professional who is knowledgeable about these transactions.

How To Get a Letter of Credit

Contact your bank to obtain a letter of credit. Working with a commercial division or the department of international commerce will probably be necessary. Although not all financial institutions provide letters of credit, small banks and credit unions can frequently direct you to someone who can meet your needs.

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Frequently Asked Questions (FAQs)

How do you apply for a letter of credit?

You can ask your bank for a letter of credit. Getting all the information about the transaction together—including the items or services being traded, the payment amount, the anticipated delivery date, and other pertinent information—may be the most difficult element of the application process. Your bank will determine whether or not they wish to provide a letter of credit after hearing about the scenario from you.

How much does a letter of credit cost?

Letters of credit are not subject to a defined cost. Costs will be determined by the bank you pick. You can anticipate paying a certain percentage of the amount the letter of credit covers. This amount will depend on factors including your credit history but is normally no more than a few percentage points.

What is a letter of credit from a utility company?

These letters of credit are distinct from the ones previously mentioned. Some utilities allow new customers to forego the security deposit and instead submit a letter of credit from their prior utility company. Your previous utility provider will inform your new provider that you are a trustworthy customer if you never missed a payment. Also known as “credit reference letters,” these.

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