Letter of Credit simplified explanation | What is a Letter of Credit? | Essay on Letter of Credit

What is a letter of credit?

A letter of credit which is also known as 'documentary credit' is basically a guarantee from a bank that a particular seller will receive a payment due from a particular buyer. The bank guarantees that the seller will receive a specified amount of money on a specified time. In return for guaranteeing the payment, the bank will require that strict terms are met. It will want to receive certain documents for example shipping confirmation - as proof. The bank also charges a commission from the seller to issue a guarantee moreover it safeguards its position by getting adequate collateral/ counter guarantees to the LC amount involved.

Why to use a letter of credit?

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 main advantage of using a letter of credit is that it can give security to both the seller and the buyer.

Advantages for sellers

By asking for an appropriate letter of credit a seller is reassured that they will receive their money in full and on time. A letter of credit is one of the most secure methods of payment for exporters as long as they meet all the terms and conditions. The risk of non-payment is transferred from the seller to the bank (or banks).

Advantages for buyers

When a buyer uses a letter of credit they get a guarantee that the seller will honour their side of the deal and provide documentary proof of this.

Other things to consider

It's important to be aware of the additional costs involved in using a letter of credit. Banks make charges for providing them, so it's sensible to weigh up the costs against the security benefits.

Exporters should be aware that they will only receive payment if they keep to the strict terms of the letter of credit. They has to give documentary proof that they have supplied exactly what they have contracted to supply. Using letter of credit may sometimes cause delays and other administrative problems.