As the term simply indicates a document pertaining to credit or loans, a Letter of Credit issued when the seller promises the exchange of goods and services on the condition that the buyer provides acceptable credit documentation. As one of the major concepts you will come across while studying banking courses, a Letter of Credit is generally issued by banks and often renowned financial institutions as a promise that the payment will be made once the other party abides by the laid down conditions. This blog explores Letter of Credit in further detail, from its meaning, types to different elements.
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What is Letter of Credit?
A letter issued from the bank or any reputed financial institution stating that the buyer’s payment to a seller will be sent/received on the determined time for the set payment is known as a Letter of Credit. Often regarded as a facility by a bank, the chosen respective bank will bear the entire or partial cost if the buyer is unable to make the payment of the purchase. There are ample types of LOC and they vary in their nature with respect to the buyer or seller when buying or selling a product or service. Here are the major factors considered while elucidating types of LOC:
In this situation when the payment is made by the buyer and the company fails to provide the service or the product, then such buyers can get paid back by showing LOC. A penalty to the company that failed to deliver the product will be made and hence, the amount has to be returned. You can further use that money to avail that service/product from somewhere else.
If a buyer is unable to deliver the due or entire payment of a product or service purchased, then the seller can be benefitted by the letter of credit. In such scenarios, if the seller meets all the requirements as mentioned by the bank, then the bank must pay the seller. This is an advantageous step in terms of international business as the buyers and sellers are far away.
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Types of Letters of Credit
There can be several situations between a buyer and a seller in a business environment and since the Letter of Credit aims to benefit both, there are multiple types of LOCs. Mentioned below are the popular types of credit letter:
Commercial Letter of Credit
This can be considered as the direct or primary payment method when the beneficiary receives payment from the issuing bank.
Standby Letter of Credit
It is known as the secondary method of payment, wherein the beneficiary gets paid by the bank only if the holder cannot.
Traveller’s Letter of Credit
Through this letter, the respective bank will guarantee that they will honour the draft made at any reputed foreign bank.
Revolving Letter of Credit
Out of all the types of LOCs, the customer has multiple numbers of draws within a determined limit and in a fixed time period for a Revolving Letter of Credit.
Confirmed Letter of Credit
There are two banks involved in a confirmed letter of credit. Firstly, the issuing bank guaranteeing the letter of credit along with another bank. Out of these two, the second bank is called the confirming bank which will be directly in touch with the seller and will be the seller’s bank. The confirming bank will make sure that the payment is made via the LOC if in any case the issuing bank and the holder defaults.
Elements the Letter of Credit
The LOC consists of the following major elements indicating the issuing party, the seller and the buyer as well as goods and services, amongst others.
- Issuing Bank
- Freight Forward
- Advising Bank
- Legal Counsel, etc.
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Now that you understand the concept of Letter of Credit, let’s go through some of the essential documents required for it. However, a uniform format of the LOC can not be determined as it varies from bank to bank.
- Shipping and transport documentation
- Insurance policies or certificates
- Official documents like license, inspection certificate, etc
- Bills of exchange
Thus, we hope that through this blog, you are familiarised with Letter of Credit and its essential features and types. Planning to pursue a career in Finance or Banking? Reach out to our Leverage Edu experts and we’ll guide you in selecting a suitable course and university that can equip you with the necessary knowledge and exposure to build a rewarding career in your chosen field. Sign up for an e-meeting today!