Letter of credit explained: What it is, how it works & types

International trade can be a smart way to expand your business. The majority of U.S. businesses that export are small businesses (97%) and small exporting businesses tend to outperform non-exporting businesses across a swath of performance measures, according to research from the U.S. Small Business Administration Office of Advocacy.

But getting paid is a hurdle that can seem daunting. Overseas buyers aren’t likely to want to pay for their purchases until they receive your product, but you may not want to ship your product until you know you’ll get paid. 

This is where letters of credit come in. 

Letters of credit are financial tools that help make international trade possible by giving both sides the security they need to transact international business.

What is a letter of credit?

A letter of credit is a bank's written promise to pay a seller on behalf of a buyer, assuming the seller meets specific terms and conditions. It is a guaranteed payment mechanism backed by a financial institution.

For exporters and businesses engaged in global commerce, letters of credit are a critical tool for cash flow management. They can provide a level of bank-backed assurance that helps reduce risk.

In some parts of the world, letters of credit are called documentary letters of credit or simply documentary credit because they rely on documents proving that terms were met before releasing payment. 

Letters of credit are most common in international trade, but they can also be used domestically in large transactions or situations involving unfamiliar business partners. 

However, due to the cost, they are most often used in significant foreign trade transactions where payment enforcement can be difficult or where exchange rate fluctuations create uncertainty.

How does a letter of credit work?

Here’s how the process of getting a letter of credit typically works. In this case you are the seller who will be shipping your goods to an unknown seller. 

1. Buyer and seller agree on terms. You negotiate a sales contract with your customer that includes the purchase price, delivery timeline, product specifications, and payment terms. Both parties agree that payment will be made through a letter of credit.
2. Buyer applies for the letter of credit. The buyer (called the "applicant") contacts their bank and requests a letter of credit. They provide details about the transaction, including the amount, beneficiary (your business; in this case the seller), and conditions that must be met.
3. Issuing bank evaluates the buyer. The bank reviews the buyer's creditworthiness, financial statements, and business history to determine whether the buyer can back up the letter of credit. The bank typically requires collateral, a cash deposit, or proof of sufficient funds before proceeding.
4. Bank issues the letter of credit. Once approved, the issuing bank creates the letter of credit document. This specifies the exact amount to be paid, the deadline for shipment or delivery, required documentation, and any other conditions that must be met to receive payment.
5. Your bank receives the letter of credit. The issuing bank sends the letter of credit to your bank (called the advising bank). Your bank reviews the document, confirms its authenticity, and notifies you that the letter of credit has been received. You should review all terms carefully before proceeding.
6. You ship your goods. With payment guaranteed, you prepare and ship the products according to the terms specified in the letter of credit. This might mean shipping by a certain date, using a specific carrier, or meeting particular packaging requirements.
7. You submit required documents. After shipping, you gather all required documentation, which often includes the commercial invoice, bill of lading, packing list, and insurance certificate. You submit these to your bank, which forwards them to the issuing bank.
8. Banks verify compliance. The issuing bank examines your documents carefully to ensure you met every condition specified in the letter of credit.
9. Payment is released. If all documents are in order and all conditions met, the issuing bank releases payment to your bank, which then deposits the funds in your account. Depending on the letter of credit terms, payment might be immediate, deferred to a future date, or upon final delivery confirmation
10. Buyer receives documents. After paying (or arranging for deferred payment), the buyer receives the shipping documents from their bank. These documents allow them to claim the goods when they arrive at the destination port.

The timeline for navigating this process varies. A buyer and seller with international trade experience and strong banking relationships might expect one to two weeks for the letter of credit to be issued and another one to two weeks for document processing and payment after shipment. 

Key players in a letter of credit transaction

Letter of credit transactions of credit take a team to make them work properly. Here are the key players involved:

• Applicant (buyer). This is the customer purchasing your goods who requests the letter of credit from their bank. They're responsible for paying the bank's fees, providing collateral if needed, and ultimately reimbursing the bank for the payment made on their behalf.
• Beneficiary (seller). You, the business shipping goods and receiving payment. You must meet all conditions specified in the letter of credit to collect the funds. 
• Issuing bank. The buyer's bank that creates the letter of credit and guarantees payment. They evaluate the buyer's creditworthiness, specify the terms and conditions, review all documents submitted, and release payment when conditions are met. The issuing bank charges fees for this service and takes on the risk of buyer non-payment.
• Advising bank. Your bank that receives the letter of credit from the issuing bank. They authenticate the document to ensure it's legitimate, help you understand terms, and forward your shipping documents to the issuing bank. The advising bank doesn't guarantee payment — they just facilitate communication.
• Confirming bank (if used). A second bank, usually in your country, adds its own payment guarantee to the letter of credit. This provides extra security if you're concerned about the issuing bank's ability or willingness to pay. The confirming bank charges additional fees but offers peace of mind, especially when dealing with banks in countries with economic or political instability.

Other parties may include:

• Negotiating bank: A bank that purchases or advances funds against your documents before the issuing bank pays. This can speed up cash flow.
• Reimbursing bank: An intermediary bank that handles payments between the issuing and advising banks, particularly in complex international transactions.
• Freight forwarder and shipping company: They provide the bills of lading and other shipping documents required to prove you met the letter of credit conditions.
• Legal counsel: Lawyers who help draft terms, resolve discrepancies, or handle disputes if things go wrong.

The more banks or parties involved, the more complex (and expensive) the transaction becomes. Simple transactions might involve just an issuing bank and an advising bank, while more complex international deals might require several institutions.

Types of letters of credit

Different types of letters of credit serve different business needs. Understanding these variations helps you choose the right protection for your transaction.

Commercial letter of credit

The most common type used for routine purchase transactions in international trade. The issuing bank pays the seller directly upon receiving proper documentation proving the goods were shipped according to the agreed terms.

Commercial letters of credit are designed for transactions where goods exchange hands — you ship products, you get paid. The bank handles the entire payment process, not just serving as a backup.

Often used for: Regular import/export transactions, purchases from new suppliers, and any situation where you want guaranteed payment for shipped goods.

Standby letter of credit

Here the letter of credit functions as a backup payment method rather than the primary payment mechanism. The buyer pays you directly, and the bank only steps in if the buyer fails to pay. Think of it like you would insurance against buyer default.

Standby letters of credit are often used in domestic transactions or service contracts where payment is expected to happen through normal channels. The letter provides security if something goes wrong.

Often used for: Service contracts, construction projects, lease agreements, or situations where you expect normal payment but want protection against non-payment.

Confirmed vs. unconfirmed letter of credit

An unconfirmed letter of credit has only the issuing bank's guarantee. If that bank fails or refuses to pay, you're at risk. A confirmed letter of credit adds a second bank's guarantee — usually a bank in your own country — providing double protection.

Confirmation costs extra (typically 0.5% to 1% of the transaction value), but it can be worth it when dealing with:

• Banks in countries with economic instability
• Banks you're unfamiliar with or that have questionable financial strength
• Very large transactions where the risk exposure is significant
• Countries with currency controls or political uncertainty

Often used for: High-risk transactions, dealings with unfamiliar foreign banks, or situations where extra security justifies the added cost.

Transferable letter of credit

Allows you (the first beneficiary) to transfer all or part of the letter of credit to one or more second beneficiaries. This is useful when you're acting as a middleman — you receive an order and letter of credit from a buyer, but you need to purchase goods from a manufacturer to fulfill that order.

You can transfer the letter of credit to your supplier, who then ships directly to your customer. The payment flows through the letter of credit, reducing your cash flow burden.

Often used for: Trading companies, brokers, and businesses that source products from manufacturers to fulfill customer orders.

Revocable vs. irrevocable letter of credit

A revocable letter of credit can be modified or canceled by the issuing bank at any time without your consent. This offers almost no protection and is rarely used today.

An irrevocable letter of credit cannot be changed or canceled unless all parties (including you, the seller) agree to the modifications. This is now the international standard — most letters of credit are irrevocable by default.

Unless specifically stated otherwise, assume a letter of credit is irrevocable. This gives you the security you need to ship goods with confidence.

Often used for: Nearly all transactions. Always insist on an irrevocable letter of credit unless you have a very strong existing relationship with the buyer and their bank.

Letters of credit types

Letter of credit vs. bank guarantee

While both instruments provide payment security backed by a bank, each serves a different purpose and are used differently:

Here's a practical example of the difference:

Letter of credit scenario: You're exporting machinery to Brazil. Your buyer's bank issues a letter of credit for $100,000. The letter of credit ensures you get paid for goods you've already shipped.

Bank guarantee scenario: You're a contractor building a warehouse. The property owner requires a performance bond (bank guarantee) for $200,000. If you fail to complete the work or don't meet specifications, the owner can claim against the guarantee to cover their losses. The bank guarantee ensures the project owner is protected if you don't perform.

You may want to think of letters of credit as "pay me for what I shipped" and bank guarantees as "compensate me if they don't deliver."

Benefits and risks

Letters of credit can offer real protection but with a price, of course.

For sellers: You get guaranteed payment from a bank instead of relying on a buyer who might default. This turns an uncertain foreign payment into bankable certainty. You'll know exactly when payment arrives, and some lenders will even advance funds against the letter before the buyer pays.

For buyers: Payment only releases when documents prove goods have been shipped as agreed. You negotiate the conditions that must be met — inspection certificates, quality standards, shipping requirements. Some letters allow deferred payment, improving your cash flow.

The downsides: Banks scrutinize every detail. A misspelled name or wrong date can block payment. Fees run 0.75% to 2% of the transaction (or more), plus charges for amendments and document handling. The process can take several weeks. If terms need to be changed after issuance, amendments are expensive and require everyone's agreement.

You can also face document complexity, potential bank risk if the issuing bank fails, and currency exposure if payment is in foreign currency.

For most international deals with unfamiliar buyers or higher-risk countries, the security justifies the cost and paperwork.

Letter of credit example

Here's an example of how this type of transaction might work:

Sarah owns a clothing brand in Texas that sources organic cotton garments from a manufacturer in India. She found a new supplier offering better prices, but she's never worked with them before and is nervous about sending a $75,000 payment overseas without guaranteed delivery.

The supplier, for their part, is concerned about manufacturing custom garments for a new U.S. customer who might cancel the order after production begins.

Both parties agree to use a letter of credit to protect their interests.

Step by step:

1. Sarah and the Indian supplier agree on the order details: 5,000 garments, specific quality standards, delivery within 90 days. The contract specifies payment through a letter of credit.
2. Sarah applies to her bank for a letter of credit for $75,000. Her bank reviews her business finances and requires a $25,000 cash deposit as collateral.
3. Sarah’s bank issues the letter of credit and sends it to the supplier's bank in Mumbai. The letter specifies:
4. • Payment of $75,000 upon presentation of documents.
   • Required documents: commercial invoice, packing list, bill of lading, certificate of origin.
   • Shipping deadline: 90 days from letter issuance.
   • Inspection certificate confirming garments meet specifications.
5. The Indian supplier's bank notifies them that the letter of credit has been received. The supplier reviews the terms and confirms they can meet all conditions.
6. Confident that payment is guaranteed, the supplier manufactures the garments and ships them by the specified deadline using the required shipping method.
7. After shipping, the supplier gathers all required documents and submits them to their Mumbai bank. The bank reviews the documents for compliance.
8. The Mumbai bank forwards the documents to Sarah’s bank, which examines them carefully. Her bank notices the shipping date is one day late according to the letter of credit terms — a discrepancy.
9. Sarah’s bank notifies her of the discrepancy. Sarah confirms she'll accept the late shipment since the garments are needed anyway. She authorizes her bank to waive the discrepancy and process payment.
10. Sarah’s bank in the US releases $75,000 to the supplier's Mumbai bank, minus fees. The supplier receives payment (minus their bank's fees).
11. Sarah receives the shipping documents from her bank, allowing her to claim the garments when they arrive at the U.S. port.

Here, both parties are protected. The supplier doesn't manufacture $75,000 worth of custom goods without payment certainty. Sarah doesn't pay $75,000 without proof the goods were shipped. The letter of credit creates trust between strangers doing international business.

Sarah’s bank charged her business 1.5% ($1,125) to issue the letter of credit, plus a document handling fee of $250 and an amendment fee of $150 for waiving the shipping date discrepancy. The supplier's bank in Mumbai charged 0.5% ($375) for advising and document handling. The total transaction cost came to approximately $1,900, or about 2.5% of the transaction value.

Sarah considers this a reasonable cost for the security of working with an unfamiliar foreign supplier on a large order.

How much does a letter of credit cost and who pays?

Fees vary widely and if you don’t build them into your pricing you may significantly cut your profit margin. 

Typical costs: Issuance fees run 0.75% to 2% of the transaction amount. Banks set rates based on your creditworthiness, transaction size, country risk, and letter type. Confirmed letters may cost an extra 0.5% to 1.5%.

Additional charges: Advising bank fees ($100 - $500), document examination ($100 - $300), amendments ($150 - $500 each), discrepancy fees ($50 - $150), and SWIFT charges ($25 - $75).

Example: On a $100,000 letter, expect roughly $2,000 in total fees (2%). Adding confirmation pushes this to $3,000 (3%).

Who pays: Buyers typically cover issuance and amendment fees. Sellers may pay their bank's advising and negotiation fees. But you can negotiate any arrangement — split costs, one party pays everything, or build fees into product pricing.

Collateral requirements: Banks often require cash deposits or collateral, especially for newer businesses, large amounts, or higher-risk countries.

Specify the fee arrangement in your sales contract before the letter is issued. Banks may also require collateral before proceeding.

Frequently asked questions