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What Is a Letter of Credit and How Does It Work?

Andrew Secker, Private Banker, First Republic Bank
November 23, 2021

When you run a business, receiving timely payments from customers is critical, whether your clients are domestic, international or both. A handshake or a contract may be an acceptable way of ensuring you’ll get paid in full and on time, but other options, such as a letter of credit, carry more weight.

In brief, a letter of credit assures business owners that their customers and vendors will pay on time. This assurance is particularly important for businesses involved in international trade, imports or exports. Although a letter of credit is most commonly used for international transactions, some domestic applications are practical as well. 

It’s important to know the letter of credit definition, how a letter of credit works and when you might encounter one during the normal course of business.

What’s a letter of credit?

A letter of credit, also known as a credit letter, is a document from a bank or other financial institution guaranteeing that a specific payment will be made in a business transaction. Importantly, the process involves an impartial third party in the transaction.

In a letter of credit, the issuing bank affirms that a purchaser (in this case, a client or a customer) will pay for goods or services on time and for the exact amount due. If the purchaser doesn’t pay on time and in full, the issuing bank underlying the letter of credit guarantees to cover the remainder of the overdue balance up to and including the full amount of the purchase.

Letters of credit are particularly important in international trade. They can help an importer or exporter make deals with a greater amount of security and comfort since the business will know they’ll receive payment. Accordingly, a letter of credit provides protection for both the buyer and seller: Both parties know that the issuing bank guarantees the payment component of their transaction.

Several requirements have to be met in order for a business to receive the funds spelled out in a letter of credit. Additionally, several different kinds of letters of credit can cover a variety of scenarios.

If you think a letter of credit sounds like a fit for your business transaction, the next question to answer is: How does a letter of credit work?

How does a letter of credit work?

It is important to understand how a letter of credit operates; by design, it starts when two parties have a transactional need. One party will request a letter of credit to be provided to the receiving party.

Because a letter of credit is a document obtained from a bank or other financial institution, the applicant needs to partner with a lender to secure a letter of credit. The process is similar to applying for a loan, in which an applicant prepares and submits an application (this usually includes the purchase contract, a copy of the purchase order or export contract and a few other documents, depending on the issuing bank). Then — again, like a loan — the applicant waits for approval. 

To obtain a letter of credit, applicants will often need to work with a specific branch of a bank, such as an international trade department or commercial division. As the business applying for the letter of credit, the applicant will likely pay a fee to obtain the letter (often, a percentage of the amount the letter of credit is for).

A business that successfully obtains a letter of credit has confirmation that the financial institution is agreeing to guarantee the amount of the transaction. This establishes trust in the transaction since the buyer is guaranteed they will collect the full amount of the deal. Letters of credit may be transferable, depending on the bank or financial institution from which the letter of credit is procured.

Again, although commonly used for international trade — particularly importing and exporting — businesses can get letters of credit for domestic transactions as well.

When to use a letter of credit

A letter of credit could be useful and applicable in several situations, but some are more common than others. How does a letter of credit work in these situations?

A common scenario would be a business working with a company abroad in an international trade deal. For example, say an exporter (the seller) in the United States wants to work with an importer (the buyer) overseas. The two companies decide to work together and agree on terms of the transaction, including price, timeline and delivery date. The seller requests a letter of credit from the buyer, to ensure that the transaction will be completed in full. The buyer obtaining the letter of credit can help put the seller at ease in the deal, especially if they’ve never worked with the buyer before, no matter what happens with the other party’s finances.

Another common situation would be for a commercial lease. For example, say a tenant and a landlord agree to terms for a commercial lease, including monthly payment. In this case, the landlord could ask the tenant to obtain a letter of credit to ensure rent payments are covered in case a tenant isn’t able to pay. 

Letter of credit key terms glossary

The letter of credit process is straightforward in concept, but several key terms are involved in the letter of credit process. 

  • Applicant: The party in the transaction requesting the letter of credit from the bank or financial institution. This is the customer or buyer

  • Beneficiary: The party in the transaction that is able to draw payment based on terms of the letter of credit. This is the seller and the party that asks the customer to obtain the letter of credit

  • Issuing bank: The financial institution that reviews and approves the applicant for the letter of credit and holds onto the funds involved in the transaction 

  • Negotiating bank: The financial institution that works on the beneficiary’s side of the transaction, and pays the beneficiary in case of default. They liaise with the issuing bank

  • Advising bank: The financial institution that receives the letter of credit, and informs the beneficiary when the applicant’s bank approves the letter of credit

  • Confirming bank: The financial institution that guarantees the payment to the beneficiary

  • Intermediary: A third-party that can help applicants and beneficiaries sort out details of a letter of credit

It’s important to note that sometimes some of these banks will take on multiple roles in the same transaction.

A letter of credit comes with various benefits and limitations that you’ll want to familiarize yourself with before obtaining one.

The benefits and limitations of a letter of credit

Businesses on both sides of the transaction should consider the several benefits and a few potential drawbacks of a letter of credit before going through the process of obtaining one.

Benefits

Limitations

  • Provides security for sellers in deals, so if a customer isn’t able to pay for a transaction, the sellers can get paid without issue.

  • Builds trust and security in transactions, especially international trade deals, and often when parties haven’t worked together before

  • Can provide detailed, written guidelines for when a buyer needs to provide money during a transaction

  • With third-parties involved, the exchange of money can often happen more efficiently than going direct from buyer to seller, especially in international trade deals where laws may be difficult to navigate

  • Highly customizable, and can be written to satisfy the terms of individual deals

  • Costs a fee for the buyer to obtain, and is sometimes not an option if buyers want to deal with particular sellers

  • Doesn’t cover all aspects of transactions, such as the speed at which goods arrive, the quality with which they arrive, etc.

  • Doesn’t account for mitigating circumstances in transactions, such as inflation affecting foreign exchange rates, political unrest, supply chain issues, changing international trade laws, etc.

  • Generally can be a time-consuming process for both parties involved

Having an idea of the advantages and limitations of a letter of credit will set you up to determine whether one type of letter of credit would be the best option for your situation. 

 

Types of letters of credit

There are several types of letters of credit with their own benefits and considerations. Some are more common than others, and some types of letters of credit are useful for unique scenarios.

●  Commercial letter of credit: Involved in commercial transactions, often in international trade deals. The bank makes a direct payment to the beneficiary in this case

●  Standby letter of credit: A secondary payment method in which the bank pays the beneficiary if they can prove it didn’t receive what was promised from the seller

●  Revolving letter of credit: Used for a series of payments when two parties expect to do multiple deals together

●  Traveler’s letter of credit: The issuing bank guarantees to honor other letters of credit drafts signed at specific foreign banks

●  Confirmed letter of credit: Generally specifies that the seller’s bank ensures that the seller will get payment in the event that both the buyer and its issuing bank default

Once you understand the different types of letters of credit and how they work, you can better understand whether requesting or acquiring a letter of credit is something your business can or will benefit from in the future.

Why should my business use a letter of credit?

Letters of credit can act as indispensable tools for guaranteeing payment to buyers and sellers in many situations in both international trade and domestic transactions. This not only helps payment go smoothly in deals with complicated details, such as international laws, but also helps build and strengthen relationships between new vendors just beginning to do business together.

First Republic Bank offers standby letters of credit to provide peace of mind to all parties ahead of key financial transactions, like signing a new lease agreement or taking out a construction loan or business line of credit. Consider using a letter of credit to ensure that projects aren’t held up due to credit concerns.

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