Using a Letter of Credit: What You Need To Know

What Is a Letter of Credit?

A letter of credit, also known by other names such as a documentary credit or a letter of undertaking, is official correspondence issued by a bank guaranteeing that an individual or business can draw money from an account with that bank up to a designated limit. The individual or business presents the letter when making a purchase to assure the seller that their credit is good. 

Should the buying party default on their debt to the seller, the bank that issued the letter becomes responsible for paying the seller. Similarly, if the selling party defaults on delivery of goods or services to the buyer, they may become liable to repay the bank which issued the letter.

These letters frequently are used to guarantee international financial transactions when there is some uncertainty about a buyer’s credit. Because the buyer’s bank is known to have good credit, the guarantee provided by a letter reduces credit risk to the seller and their bank and other financial providers. Commonly, these letters are used for financing importing and exporting businesses and, less frequently, by international travelers.

A Letter of Credit Example

Let’s say a U.S. furniture importer wants to start using a German furniture exporter as a supplier. The German exporter requests that the U.S. importer provide a letter of credit. The U.S. company goes to their bank in the U.S., which gets in touch with the other company’s bank in Germany to agree upon the arrangement. 

With the agreement of the German company and their bank, the U.S. bank issues a letter on behalf of the American importer, guaranteeing it will pay the German exporter if the U.S. company fails to pay for their furniture shipments. Assured by the letter, the German exporter agrees to start shipping furniture to the U.S. importer.

How Does a Letter of Credit Work?

Rules governing letters of credit have been standardized by the International Chamber of Commerce (ICC) through the business organization’s Uniform Customs and Practice for Documentary Credits (UCP). The UCP was introduced in 1933 and was updated most recently in 2007. The 2007 update is known as the UCP 600. The ICC is a private regulatory body rather than a legal authority, but its UCP 600 standards reflect common practice.

To Break It Down

Under the terminology standardized by the UCP 600, the party who applies for a letter from their bank is known as the applicant. An applicant typically seeks a letter because another party they wish to buy from has requested them to provide one as a guarantee of creditworthiness. This second party is known as the beneficiary of the letter. The applicant also can be referred to as the buyer, while the beneficiary is called the seller.

On the applicant’s end, the bank which provides the letter for the applicant is known as the issuing bank.

On the beneficiary’s end, the bank which works with the issuing bank and any other banks involved is known as the negotiating bank. Usually, this is the bank the beneficiary normally does business with.

In Some Cases

The beneficiary or their bank may request that in addition to the guarantee provided by the issuing bank, the letter receives backing by another guarantee from a bank in their own country they trust. This additional bank becomes known as the confirming bank. It may be the same as the beneficiary’s bank, or it may be another bank.

The bank that receives the letter of credit from the issuing bank and advises the beneficiary that the letter is available is known as the advising bank or notifying bank. This can be the same as the negotiating bank or confirming bank.

Types of Letters of Credit

Letters of credit are divided into different categories based on factors such as:

• How many draws the applicant may make, how the beneficiary is paid
• When the credit is released
• Who guarantees the applicant’s credit
• Whether the terms of the letter can be altered

Revolving

A revolving letter of credit allows the applicant to make multiple draws. It is useful for applicants who need letters of credit frequently and don’t want to apply for new ones repeatedly. A revolving letter usually is good up for a set length of time or up to a set limit.

Commercial

With a commercial letter of credit, the issuing bank directly pays the beneficiary so that the letter functions as an instrument of payment. 

A commercial letter of credit may be called an import letter of credit when issued to an importer and an export letter of credit when issued to an exporter.

Standby

With a standby letter of credit, the issuing or confirming bank only pays the beneficiary if the applicant fails to meet a payment obligation. 

This type of letter of credit, which is a legal document, serves as a type of insurance rather than serving as an instrument of payment as a commercial letter does.

Sight

With a sight letter of credit, the beneficiary receives credit immediately after submitting acceptable documentation of the letter to the appropriate bank.

Deferred

With a deferred letter of credit, also known as a usance or term letter of credit, the beneficiary doesn’t receive credit until a designated period has lapsed. For example, a beneficiary selling goods to an importer may give the importer time to sell the goods and collect payments.

Confirmed

A confirmed letter of credit is one guaranteed by a confirming bank in addition to the issuing bank.

Irrevocable

An irrevocable letter of credit can’t be modified without explicit agreement from all parties involved. This includes the applicant, the beneficiary and the issuing bank. In theory, a letter of credit may be revocable. That means it is subject to alteration without the agreement of all parties. 

In practice, UCP 600 regulations consider all letters of credit irrevocable even if there is no explicit indication to this effect. Revocable letters of credit are becoming increasingly rare.

Traveler’s

A traveler’s letter of credit, also called a circular letter of credit, guarantees that the issuing bank or confirming bank will ensure drafts made at designated foreign banks. This version is less commonly used than it once was.

When Do You Need One?

A common reason for using a letter of credit is that you’ve received a request for one from a foreign company you’re buying from which wants a guarantee of your credit. This protects the company. It also provides some protection should the other company fail to deliver on goods or services. The financial provider which issued your has an interest in helping you recover your money.

Another reason for obtaining this kind of letter is when you’re traveling abroad. This used to be a common practice. It’s been increasingly replaced by other forms of financing such as traveler’s checks, credit cards or prepaid debit cards.

What Do Letters of Credit Cost?

Letter of credit fees normally cost a percentage of the amount being guaranteed, often as much as 1% to 2% or higher. You may have to pay additional fees and provide collateral as well.

How Do You Get One?

You can get a letter of credit from a bank or financial institution which provides them. This may be handled within the bank’s commercial department, international trade department or another specialized division.

With most service providers, you will need to meet certain qualifying requirements. Typically, this will include having a good credit score.

Use a Letter of Credit to Guarantee Your International Financing Transactions

A letter of credit is a document from a financial provider. It guarantees your credit when you’re doing business in foreign countries. It’s most commonly used in business when you’re engaged in importing or exporting and a company in another country requests a guarantee of your credit.

Characteristics vary: 

• Revolving letters allow you to make more than one draw without applying for a new letter
• Commercial letters are paid by your credit provider to the party you’re doing business with as an instrument of payment
• Standby letters are paid by your provider only in the event you default on an obligation 
• Sight letters release credit immediately upon submission of documentation
• Deferred letters wait for a designated period
• Confirmed letters are guaranteed by a second financial institution in addition to the provider’s bank

These letters cost a percentage of the amount being guaranteed, which may run 2% or more. Plus, there may be additional fees and collateral in some cases. You can obtain one from a financial institution that handles them. This usually is done through a department such as a commercial or international trade division. 

If you do importing or exporting, you may wish to include letters of credit when considering business financing options.