What is a Letter of Credit?

When importing or exporting goods overseas, there are a number of aspects that involve risk, including:

  • Finding customers
  • Packaging and shipping products
  • Customs regulations for different countries
  • Different taxes
  • Making and receiving payments
  • Receiving delivery of products

Exporters run the risk of buyers failing to pay for goods and importers risk paying but never receiving the items they’ve ordered. When shipping internationally, because of the distances involved and cultural differences, it may be difficult to resolve any disputes that arise.

How do companies overcome this problem? Through a letter of credit. This is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make the payment on the purchase, the bank is required to cover the full or remaining amount of the purchase.

How does a letter of credit work?

Letters of credit are most commonly used when a buyer in one country purchases goods from a seller in another country; the seller may ask the buyer to provide a letter of credit to guarantee payment for the goods.

The nature of international trade – including factors such as distance, differing laws in each country, and difficulty in knowing each party personally – has seen the use of letters of credit become very important. The main advantage of using a letter of credit is that it can give security to both the seller and the buyer.

The importer (buyer) and exporter (seller) agree on a price and quantity and specify how and when the goods will be shipped to the buyer. As part of the agreement, the seller might want the buyer to use a letter of credit to guarantee payment because this is the first time they’ve done business together.

In return for guaranteeing payment, the bank will require that strict terms are met (see examples of terms under How to get paid with a letter of credit). The bank will want to receive certain documents – for example, shipping confirmation – as proof. If you’re an exporter you should be aware that you’ll only receive payment if you keep to these strict terms. You’ll need to provide documents of proof that you’ve supplied exactly what was agreed.

The bank will only issue a letter of credit if confident that the buyer will pay. This means that some buyers have to pay the bank upfront or allow the bank to freeze funds held. Others may use a line of credit with the bank, effectively take out a loan.

Sellers must trust that the bank issuing the letter of credit is legitimate and will pay as agreed. This is why sellers will typically get a letter of credit confirmed by a bank in their home country.

There are also different types of letters of credit available, depending on the needs of those issuing them. For example, if a seller has any doubts about a bank they can use a confirmed letter of credit, which means that another bank will guarantee payment.

What are the different types of letter of credit?

There are five commonly used letters of credit. Each has different features and some are more secure than others. Sometimes a letter of credit may combine two types, such as confirmed and irrevocable.

Revocable:

A revocable letter of credit can be changed or cancelled by the bank that issued it at any time and for any reason.

Irrevocable:

An irrevocable letter of credit cannot be changed or cancelled, unless everyone involved agrees. Irrevocable letters of credit provide more security than revocable ones.

Confirmed and unconfirmed:

When a buyer arranges a letter of credit they usually do so with their own bank, known as the issuing bank. The seller will usually want a bank in their country to check that the letter of credit is valid.

For extra security, the seller may require the letter of credit to be ‘confirmed’ by the bank that checks it. By confirming the letter of credit, the second bank agrees to guarantee payment even if the issuing bank fails to make it. A confirmed letter of credit provides more security than an unconfirmed one.

Transferable:

A transferable letter of credit can be passed from one ‘beneficiary’ (person receiving payment) to others. They’re commonly used when intermediaries are involved in a transaction.

What is a standby letter of credit?

A standby letter of credit is an assurance from a bank that a buyer is able to pay a seller. The seller doesn’t expect to have to draw on the letter of credit to get paid.

What is a revolving letter of credit?

A single revolving letter of credit can cover several transactions between the same buyer and seller.

How do I set up a letter of credit?

To get a letter of credit, contact the bank you currently do business within your home country. You’ll most likely need to work with an international trade department or commercial division. Not every institution offers letters of credit, but small banks and credit unions can often refer you to somebody who will accommodate your needs.

You’ll need to provide information to the bank so that they can issue the letter of credit, this may include but isn’t limited to:

• The total amount of the payment
• The seller’s name and address
• The date of shipment
• How it will be shipped
• Where the shipment will arrive

On issue, the letter of credit will be sent to your bank where you can review it. Make sure it matches what you’ve agreed to and that you can meet the terms before you produce/ship the goods.

How to get paid with a letter of credit:

The type of requirements you might need to meet include:

• Shipping goods by a certain date
• Having goods inspected before shipment
• Using a shipping method specified in the letter of credit
• Shipping to and from ports specified in the letter of credit
• Gathering and submitting documents specified in the letter of credit, such as shipping documents
• Submitting documents to the bank by a certain date

As long as you meet the terms specified – your documents are submitted to the bank and verified – you can reap the rewards of a letter of credit. That is, even if your customer refuses to pay or the goods get damaged during shipment, you can still get paid. How soon you receive payment will depend on the type of letter of credit used.

Are there any disadvantages to using a letter of credit?

Overseas transactions are often complex and a letter of credit can help but there are certain pitfalls you should be aware of. Using a letter of credit can cause delays and come with administrative problems and fees so you must weigh up the costs against the security benefits.

While letters of credit are helpful tools to reduce risk when importing and exporting, they only work when you get all of the details right. The manual processing and handling of a letter of credit is the main culprit in many B2B payment errors. A minor mistake in the document, or lack of agreement among all parties involved (buyer, supplier, banks and other members of the supply chain) can lead to gridlock and non-payment.

If you rely on a letter of credit to receive payment, then make sure you:

• Carefully review all requirements for the letter of credit before agreeing to any deal
• Understand all of the documents required. If you don’t know what something is, ask your bank
• Ensure you’ll truly be able to get all of the necessary documents for the letter of credit
• Understand the time limits associated with the letter of credit, and whether or not they’re reasonable
• Know how quickly your service providers (freight forwarding companies etc.) will produce documents for you
• Can get the documents to the bank on time
• Make all documents required by the letter of credit match the letter of credit application exactly – even typographical errors or common substitutions can cause problems
• Are aware of any additional costs involved in using a letter of credit as banks make charges for providing them

Letters of credit have become a crucial part of international trade, due to differing laws in each country and the difficulty of knowing each party personally, and should be seriously considered if you’re exporting or importing goods. Using a letter of credit will allow you to significantly reduce the risk of non-payment for ordered or delivered goods, by placing the risks in the hands of the banks.

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