If you’re an importer/exporter dealing in international trade, “letter of credit” is a term you encounter often. It is one of the most trusted trade finance instruments to mitigate risks in global trade transactions. Yet, the term can be confusing for many people, especially those who are seeking secure means of payment in overseas dealings.
This article discusses some of the most common FAQs you have regarding a letter of credit service. Check out here:
1. What is a Letter of Credit?
The most popular trade finance instrument, letters of credit are the legal documents issued by the buyer’s/importer’s bank in favor of the overseas exporter/seller, guaranteeing an on-time & full-fledged payment for the ordered goods & services. However, if a buyer/importer fails to comply with the terms and conditions or is unable to pay the amount, the issuing bank will pay the exporter instead.
2. How does a Letter of Credit service work?
1. At first, the applicant or buyer/importer must approach an issuing bank to issue an LC in favor of the exporter.
2. Then, the advisory bank (exporter’s bank) receives the letter of credit and further forwards it to the seller after verifying the authenticity and legalities.
3. The seller ships the ordered goods as per the LC agreement and receives a bill of lading as proof of shipped goods.
4. Now, the seller presents the bill of lading to the nominated or negotiating bank.
5. After checking whether the goods have been delivered or not, the bank pays the seller.
6. The negotiating bank forwards the shipping documents to the issuing bank to release the payment.
7. Then, the issuing bank sends these documents to the buyer and requests approval.
8. The buyer pays the issuing bank, and the bank forwards the amount to the negotiating bank.
Want to know how to get a letter of credit from a bank to import goods from overseas? Visit our blog.
3. How Many Types of Letters of Credit are There?
1. Revocable and Irrevocable LC
2. Confirmed and Unconfirmed LC
3. Revolving Bank Credit Letter
4. Transferable and non-transferable LC
5. Standby Letter of Credit (SBLC)
6. Back to Back LC
7. Red Clause LC
8. Green Clause LC
9. Credit on Sight LC
10. Time credit LC
11. Usance Letter of Credit
12. Commercial Letter of Credit
13. Export/Import LC
14. Traveler's Letter of Credit
15. Time Credit/Acceptance Credit
Know the different types of bank guarantees here.
4. What is the difference between a Letter of Credit and a bank guarantee?
Letters of credit and Bank guarantees, both are legal guarantees from lending institutions regarding on-time payment to the exporter by the importer. However:
Under a letter of credit service, the issuing bank guarantees that the seller will be timely & full-fledged paid by the importer. But if the importer defaults, the issuing bank will compensate the exporter instead.
On the other hand, a bank guarantee is a legal trade finance instrument where the issuing bank will pay the seller only if the buyer defaults in paying or fulfilling the T&C of the agreement.
5. How does an LC benefit importer/exporter?
This is how an LC benefits both importers-exporters:
1. It serves as proof of creditworthiness for the buyer/importer
2. Ensures on-time payment to the seller
3. Expansion of international trade activities
4. Mitigates risks of payment failure
5. It is highly customizable.
6. Shifts risks from the buyer to the issuing bank
7. Backed by a legal guarantor, etc.
6. How much do I need to pay for an LC?
Depending on the type, size, volume, nature of the business, and quantity & type of goods, banks may charge different amounts or interest rates for a letter of credit service.
A letter of credit is a vital payment guarantee trade finance instrument that removes overseas trade risks for both the buyers & sellers.