Letters of credit are common in international trade because the bank acts as an uninterested party between buyer and seller. For example, importers and exporters might use letters of credit to protect themselves. In addition, communication can be difficult across thousands of miles and different time zones. A letter of credit spells out the details so that everybody's on the same page.
Letter of Credit Lingo
To better understand letters of credit, it may help to know the following:
- Abbreviations for 'letter of credit' include L/C, LC, and LOC
- Applicant - the buyer in a transaction
- Beneficiary - the seller or ultimate recipient of funds
- Issuing bank - the bank that promises to pay
- Advising bank - helps the beneficiary use the letter of credit
The Money Behind a Letter of Credit
A bank promises to pay on behalf of a customer, but where does the money come from?
The bank will only issue a letter of credit if they know the buyer will pay. Some buyers have to deposit (or already have) enough money to cover the letter of credit, and some customers use a line of credit with the bank. Sellers must trust that the bank issuing the letter of credit is legitimate.
Executing a Letter of Credit
A seller only gets paid after performing specific actions that the buyer and seller agree to.
For example, the seller may have to deliver merchandise to a shipyard in order to satisfy requirements for the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that he made delivery. The letter of credit now must be paid even if something happens to the merchandise. If a crane falls on the merchandise or the ship sinks, it's not the seller's problem.
To pay on a letter of credit, banks simply review documents proving that a seller performed his required actions. They do not worry about the quality of goods or other items that may be important to the buyer and seller.
Pitfalls of Letters of Credit
Letters of credit make it possible to do business worldwide. They are important and helpful tools, but you should be careful when using letters of credit.
As a seller, make sure you:
- Carefully review all requirements for the letter of credit before moving forward with a deal
- Understand all the documents required
- Can get all the documents required for the letter of credit
- Understand the time limits associated with the letter of credit, and whether they are reasonable
- Know how quickly your service providers (shippers, etc) will produce documents for you
- Can get the documents to the bank on time
- Make all documents required by the letter of credit match the letter of credit application exactly
Getting a Letter of Credit
To get a letter of credit, visit your bank. Ask if they can help you with a letter of credit, or if they have any suggestions. Small banks and credit unions might not be able to accommodate you.