Know More About Letters of Credit : Meaning, Processes, Benefits, Documents Required
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A letter of credit is a financial contract that guarantees payment to the seller from a buyer. Most businesses around the nation utilise this mode of payment to conduct daily trade transactions. Since it is issued by the bank, the letter of credit ensures timely and full payment to the seller.
Besides, making transactions through this document also minimises risk pertaining to international trade transactions. Keep reading to know more details regarding a letter of credit.
A letter of credit, or a credit letter, is a letter issued by the bank that guarantees payment to a seller from a buyer for a said amount. This type of credit limit is primarily used by businesses that engage in international trading activities.
Large business transactions involve a huge corpus. If a buyer is unable to make payment for such an amount, a bank covers full or the remaining amount on behalf of him/her.
Business organisations working overseas often work with unknown suppliers. Thus, it is important for them to obtain assurance of payment before proceeding with business transactions.
Buyers engaging in major purchases may need a LC to assure a seller that they will make payment on time. In this regard, a bank issues this letter as a guarantee of payment to a seller. Consequently, the bank takes responsibility for paying off the full or remaining amount if a buyer fails to make payment.
To conduct this process, a buyer needs to prove to the bank that he/she has enough assets or a sufficient line of credit.
With regards to Letter of Credit, an issuing bank pays the amount to a beneficiary. If this letter is transferable, a beneficiary may assign some other entity the right to draw the sum.
As mentioned in the letter of credit process, several entities take part in the completion of payment through this credit route. These entities include:
Buyer
Seller
Nominated bank
Advising bank
Beneficiary
Typically, there are significant similarities between a Bank Guarantee (BG) and LC. However, they come with a major difference, which is that a LC process will continue even if a buyer defaults on payment. On the other hand, a bank reduces the loss incurred if a transaction does not go as planned in a BG.
A term loan is a lump sum amount that an individual borrows for a given tenure at an interest rate. The repayment of term loans is done through EMIs. Meanwhile, LC is a credit or loan limit sanctioned by a bank to a borrower that allows him/her to withdraw small amounts from the total sanctioned limit. A loan does not require a guarantor, however with a letter of credit the bank becomes a guarantor for a buyer.
FAQs on Letter of Credit
What advantages can a Letter of Credit offer?
One of the biggest advantages that LC offers is that it ensures a seller of timely payment from the buyer.
What is the cost of a Letter of Credit at banks?
You will typically have to pay around 0.75% to 1.5% of the transaction value depending on the issuing bank’s location.
How long does it take to obtain a Letter of Credit?
The duration of availing a letter of credit depends on the guarantor or issuing bank. However, you can obtain it within 15 days to a month.
What benefits does a Letter of Credit provide to buyers?
A letter of credit makes the payment to the seller on behalf of the buyer, if he/she fails to pay for a product on time.
Which form of collateral is needed to open a Letter of Credit?
You need to pledge your Fixed Deposit, Bank Deposit, or other assets as a collateral to obtain LC.
When would you need a Letter of Credit?
You should obtain LC while making massive international business transactions with an unknown buyer.
What happens if the buyer is unable to pay the seller under the terms of the Letter of Credit?
If a buyer is unable to pay the seller under LC terms and conditions, the bank will take responsibility and complete payment.
