What Is a Letter Of Credit?
As a person or business, there may be times when you intend to make a purchase or facilitate a transaction but don’t have the monetary funds to do so. They may have recently made a big-money purchase or failed to recoup any profit on their business. So, how do you go about it when you are unable to get money but need to finance a transaction? By seeking a letter of credit.
In simple terms, a letter of credit states that the buyer’s payment to a seller will be received on time. A bank usually writes this document and clearly states that the buyer will be able to make any required payments up to the agreed amount between both parties. However, if the buyer cannot make the required payment at the agreed period, the bank will cover the full or remaining amount for the purchase. This unique document can be offered as a facility to finance a transaction.
The use of a letter of credit is quite popular in international transactions. In fact, it can be a saving grace under certain circumstances. They have become a common part of international trades and deals. Big companies and multinationals make use of this means of finance to scale the business and cover expenses that may currently be beyond their financial capabilities. It’s widely used because both parties may require time to adjust to their laws, distance, and personality.
How Does A Letter Of Credit Work?
It’s important to note that a letter of credit is a negotiable instrument. This means that the bank will have to pay the beneficiary or whoever the buyer has nominated on the agreement. If the letter is transferable, the beneficiary can assign another entity to draw. The fact remains that banks won’t just go ahead to grant a letter of credit to anyone. They would verify a pledge of securities or collateral before deciding to grant a letter of credit. If the individual or business entity does not have enough credit to cover this deal, the bank will not honor their request.
To facilitate this form of credit, banks also receive a service fee. This fee is usually calculated as a percentage of the total value of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits is in charge of letters of credit for international transactions. There are several types of letters of credit. Each of them is designed to help individuals finance their transactions differently.
Types Of Letter Of Credit
The following are the types of letters of credit that we have today;
Commercial Letter Of Credit
This letter of credit involves a direct payment during which the bank directly settles the beneficiary. Another variation of this is the Standby Letter Of Credit. This document represents a secondary payment method in which the bank pays the beneficiary when the holder is incapable of doing so.
Revolving Letter Of Credit
This unique letter of credit offers customers something special within a specific period. It allows them to make a certain number of draws or withdrawals within a duration. This form of credit can be used to settle recurring bills at any point in time.
Traveler's Letter Of Credit
If you intend to go abroad, this letter of credit will allow the issuing bank to honor drafts made at foreign banks. This is a great idea to help you settle your financial obligations in another country if you don’t intend to stay for an extended period.
Confirmed Letter Of Credit
A confirmed letter of credit occurs when a bank aside from the issuing bank as part of the terms and agreements. The second bank, also known as the confirming bank, is the seller’s bank. It’s the bank’s job to ensure payment is made under the letter of credit provisions if the buyer and the issuing bank default. In international transactions, most issuing banks request a confirming bank from the other party.