A letter of credit, also known as a "credit letter," is a promise from a bank that a buyer's payment to a seller will be paid on time and in the correct amount which will be reflected to his business account. The bank would be obligated to cover the full or remaining amount of the transaction if the buyer is unable to make a deposit on the purchase. It could be made available as a service. The use of letters of credit has become a very significant feature of international trade due to the nature of international dealings, which includes factors such as distance, different laws of each region, and the difficulty of personally understanding each party.
Therefore in layman’s terms we can say that a letter of credit is a banking document that promises payment from a bank. Letters of credit come in a variety of shapes and sizes, and they can offer peace of mind when purchasing and selling goods and services.
- Safeguards the Seller- If a buyer fails to reimburse a seller, the bank that granted the letter of credit is obligated to pay the seller if the seller satisfies all of the letter's conditions. When the buyer and seller are in separate countries, this provides cover.
- Safeguards the Buyer- Buyers may also benefit from letters of credit. You may be able to get paid with a standby letter of credit if you pay anyone to provide a product or service and they fail to deliver. This payment can be seen as a liability for the business that was unable to operate, and it functions similarly to a refund. You will use the money to pay someone else to deliver the good or service you need.
Types–
Traveler’s letter of credit- This letter guarantees that issuing banks would respect draughts made at specific international banks for those travelling abroad.
Confirmed letter of credit- A verified letter of credit is one that has been guaranteed by a bank other than the issuing bank. The verifying deposit, which is usually the seller's bank, is the second bank. If the holder and the issuing bank default, the verifying bank guarantees payment under the letter of credit. In international transactions, the issuing bank usually demands this agreement.
Commercial letter of credit- This is a form of direct payment under which the issuing bank pays the beneficiary directly. A standby letter of credit, on the other hand, is a backup payment form in which the bank pays the recipient only if the issuer is unable to pay.
Revolving letter of credit- This type of letter allows a customer to make as many draws as they want under a certain time frame.