A letter of credit is a document issued by a bank or financial institution that guarantees that a buyers payment to a seller will be received on time and for the correct amount. It is essentially a financial contract between a bank, a banks customer, and a beneficiary. Letters of credit are often used in international trade to signify that a payment will be made to the seller on time and in full, as guaranteed by a bank or financial institution.
The process of obtaining a letter of credit involves an impartial third party in the transaction, which can act as an indispensable tool for both importers and exporters. If you are an importer, using a letter of credit can ensure that your company only pays for goods after the supplier has provided evidence that they have been shipped. It also allows you to conserve your cash flow, since you don’t have to make any advance payments or deposits to the exporter. Finally, the letter of credit gives you instant credibility with an exporter by demonstrating your creditworthiness. If you are an exporter, the letter of credit is insurance in case the buyer fails to pay for the goods you shipped. In such a case, the financial institution will cover the amount outstanding. The letter of credit also protects you against legal risks since you are ensured payment as long as delivery conditions have been met.
Banks collect a fee for issuing a letter of credit, typically a percentage of the letter of credit, in addition to requiring collateral from the buyer. The process of obtaining a letter of credit is similar to applying for a loan, in which an applicant prepares and submits an application, including the purchase contract, a copy of the purchase order or export contract, and a few other documents, depending on the issuing bank. Then, the applicant waits for approval.
