What is a letter of credit? | Definition, operation, types, pros and cons. The letter of credit is a document, also called a letter of credit, delivered by a bank or financial services. A letter of credit guarantees that the seller receives the agreed payment from the buyer. The bank pays the stipulated amount either in full or in the remaining part to the seller in case the buyer is unable to pay the amount. types of letter of credit
International transactions can be made through a letter of credit. Many different factors such as distance, laws of the respective country and unknown business parts generally affect business, letter of credit is popular as it is not affected by these factors. Banks charge between 0.25 and 2% depending on the type of margin on the letter of credit, the customer’s credit rating, tenure, and other similar factors.
How does it work?
- The letter of credit is issued by the beneficiary or any bank designated by the beneficiary.
- The letter of credit can be transferable.
- If the letter of credit is transferable, another entity can be assigned as a third parent or company that has the right to turn.types of letter of credit
- The bank’s guarantee is usually in cash or some other form of guarantee before a letter of credit is issued.
- The service charge depends on the bank; It can also be a percentage of the letter of credit.
- The International Chamber of Commerce for Customs and Uniform Practices for Documentary Credits oversees letters of credit used for international transactions.
Types of letters of credit
Commercial letter of credit
This letter of credit is issued by the bank for direct payment to the beneficiary.
A pending letter of credit
The bank issues this letter of credit only when the account holder cannot pay the beneficiary’s installments.
Revolving letter of credit
This letter of credit is issued by the bank, allowing the customer to make any number of withdrawals within a certain limit during a specific period of time.
Traveler’s letter of credit
This letter of credit is for travelers planning to travel abroad.
Confirmed letter of credit
This letter of credit is granted by the second bank, confirming the payment. The second bank is usually the seller’s bank. The confirming bank ensures that the letter of credit is honored in case the issuing bank does not pay. This letter is generally issued for international transactions.types of letter of credit
Advantages and disadvantages of the letter of credit types of letter of credit
| Advantage | Disadvantages |
| A letter of credit is useful for transacting with unknown partners or setting up new operations. | The letter of credit is very expensive, banks charge fees for providing services; additional features are at an additional cost. |
| The letter of credit offers security to the seller or exporter in case the buyer or importer goes bankrupt. The bank ends up paying as the issuing banks act as guarantors for the importer. | The letter of credit is based on quantity and not quality. The bank may end up in dispute if the quality of the exporter’s product is different from the sample. |
| A letter of credit allows both business parties to dictate terms in the letter of credit. It can also be customized for each transaction. | The letter of credit comes with an expiration date and the exporter has a time limit. |
| The letter of credit also helps resolve disputes by allowing the exporter to withdraw funds. | types of letter of credit |
