One of the challenges faced by International traders is the issue of distance. Sometimes the buyer (importer) and the seller (exporter) may never get to see each other, and there is a need to ensure that each party gets whatever they bargained for, especially the seller.
This is where a letter of credit comes into play. In this comprehensive article, we shall extensively discuss this important document, its importance, and everything you need to know. Keep reading!
A letter of credit (LC) is an important document ensuring the seller receives his or her payment. It is usually given by the buyer to the seller through the bank. With this letter, the buyer is rest assured that his payment is guaranteed both in due time and in the right amount.
Most of the banks that help prepare this document charge a fee. This means that banks do not issue the document for free.
How Does It Work?
To clearly understand how the letter of credit works, let’s take a look at a scenario.
David is an importer who deals in all kinds of clothing materials. David buys from Charles, who is from another country. To ensure that Charles receives his payment on time, David goes to the bank to obtain a letter of credit from his bank and sends it to Charles.
Seeing the document, Charles being the beneficiary, is relaxed and sure that he will get paid by David. And if he (David) fails to pay as agreed or made a partial payment, the bank that issued the letter will have to pay the amount or the remaining part of the payment.
What Happens When The Buyer Is Unable To Make Payment?
If the buyer fails to pay for the goods delivered to him or he cannot finish up with the payment, the bank that issued the credit letter will have to pay on his behalf.
There are three significant people involved in a letter of credit. They are;
- The seller (exporter): This is the beneficiary.
- The buyer (importer): This is the applicant.
- The issuing bank: This is the third party or institution that backs the importer up.
Types Of Letter Of Credit
This important document used in business transactions, especially International trade, is of different types. They are ;
- Standby letter
- A commercial letter
- Revolving letter
- Transferable letter
- Red clause letter
- Back-to-back letters
This type of letter of credit is given when the seller pays off the supplier, especially when there is evidence that the goods were delivered.
This particular letter of credit is used when the buyer’s bank is to make a direct payment and not the buyer. This is one of the common letters of credit.
In case the importer and exporter hope to do more business transactions in subsequent times, a revolving letter of credit is often used.
This type of letter of credit is usually used or issued when intermediaries are in a business deal or transaction. For example, when the buyer or seller buys through a third party.
Red Clause Letter
This letter of credit is issued when the seller (exporter) demands an upfront or down payment which remains liable after delivery.
Back To Back Letter
A back-to-back letter of credit consists of two letters. This entails that a letter of credit having double letters is used to finance a single business transaction, especially among an intermediary, the exporter (seller), and the importer (buyer).
Requirements For Obtaining A Letter Of Credit
An importer or buyer who wishes to apply for a letter of credit has to provide the following information or details;
- Choose whether the credit is to be reversible or irreversible.
- The name, address, and other important information about the exporter or beneficiary.
- The amount of credit and the currency involved in the transaction.
- The expiry date of the credit.
- The date the last shipment was made.
- A clear description of the goods or services supplied or engaged.
It is worth noting that the above are general requirements. Some banks may require more than this.
Where Can I Obtain It?
Simply head to your bank with the information or documents listed earlier and make your intention known. They will take it from there, and if they are satisfied with their findings, they may proceed with the drafting of the letter.
Meanwhile, be ready to supply any needed information or documents required by the bank in the course of the application.
How Much Does It Cost?
The letter of credit is not given for free. The applicant must pay a certain fee to the bank. This fee varies within banks and can be determined based on the amount of money involved in the deal.
Facts About Letter of Credit
Before opting for a letter of credit, consider the following:
- There are fees attached to the letter of credit
- In case of external issues in the supply chain, the letter of credit does not account for it.
- They take a longer time to be issued.
- They can be fabricated.
- They can be used for fraudulent activities, especially if there are intermediaries.
Advantages/ Importance Of Letter Of Credit
The following benefits or importance are associated with letters of credit;
- It can create safety and help build mutual understanding and trust between buyers and sellers in business deals.
- They make it easier to define when and how to finalize transactions between parties.
- They can be personalized with standards that are made to the occurrences of each deal.
- They can make the transfer of funds more efficient and hassle-free.
Disadvantages Of Letters Of Credit
There are a handful of cons or disadvantages associated with this document. The significant ones include;
- The buyer typically bears the expenses of obtaining a letter of credit from the bank.
- They do not cover every detail of the transaction, giving room for mistakes.
- Applying and obtaining the document may be stressful and time-consuming for all parties involved.
- It does not account for external changes in the transaction.
- They can be fabricated hence leading to fraud.
Letters of credit are of great importance, especially in international trade. They guarantee security to both seller and buyer and ensure mutual trust between the two parties.
However, there are disadvantages of this important document, especially in terms of fabrication and fraud. We encourage you to engage professionals when opting for one to avoid leaving room for mistakes. We believe that this article was helpful to you. Feel free to ask us questions in the comments section!