If you’re a successful small business, you’ll be getting paid by customers quite regularly. We know about most of the common ways to receive payment, such as credit cards, cash, and even wire transfers. One method that might be unfamiliar to many small business owners, however, is a letter of credit. While this payment mechanism isn’t used as often by small domestic companies in the United States—you should understand how it works. If you’re an exporter, making it part of your accounts receivable toolkit might ensure prompt, reliable remittance from buyers around the world.
What is a letter of credit?
In simple terms, a letter of credit (LC) is a promise to pay that’s backed by a financial institution and a valuable part of trade finance. If, for some reason, the customer or buyer (also known as the “applicant”) can’t come up with the money, the bank still has to make good on their guarantee to the seller. With varying international trade laws and the increasing difficulty getting prompt payment after goods are shipped, the letter of credit plays an important role in the cash flow of an exporter or global business.
Depending on what part of the world you’re from, it may also be called a “documentary letter of credit,” or simply, “documentary credit.”
How does a letter of credit work?
Think of a letter of credit as a negotiable instrument. When a bank issues one to a seller, it guarantees funds. Much like a check or money order, the letter is usually transferable. The seller (or beneficiary of the letter) can draw funds from it, or assign the benefits to someone else in what’s called a “transferable letter of credit.” They might transfer the interest to their corporate office, a lender, or someone else to whom they want to give the funds. Whoever ends up with the confirmed letter of credit can then draw the cash value from the issuing bank, like cashing a check.
What’s in it for the bank? As the issuer, they charge money to the buyer, usually a percentage of the total amount being guaranteed. To ensure that they will get paid from the buyer (or applicant), however, the bank is likely to ask for a deposit or collateral to make sure they don’t get burned from the guarantee. Making the buyer pledge securities or cash is common, especially when dealing with international transactions.
Letter of Credit Process
While the process may look slightly different, depending on your specific needs, the basics go like this:
- You, as the exporter, agree to provide goods or services to a customer or the applicant, usually located in a different country.
- Working with a bank in that same country, a letter of credit is issued to the applicant that states exactly what is expected of the buyer. This might include the purchase amount and when you expect to receive the funds. The money could be expected at shipment, point of delivery, or somewhere in between.
- During this time, the bank that issues the letter will be making sure that the buyer is good for their promise to pay. They might do background checks, credit checks, ask for deposits, and other required risk measures to make sure deferred payment will happen. They will also do the heavy lifting to get the funds from buyer to bank to you.
- Once the terms of the agreement have been met and verified, funds can be sent. Documentation from the shipping company or buyer is used to verify, including the bills of lading, invoice, and policy of insurance.
If this all sounds familiar, it’s because it works much like an escrow account. When you buy a home, for example, a bank might hold the deposit in a separate account until the sale is completed. This ensures that the seller gets paid and that there are no complications between buyer and seller.
Of course, this is just a simplified explanation. Things can be more complicated, depending on the type of letter of credit issued, the amount involved, and the country in which you’re doing business. International law can get tricky, which is why banks that offer letters of credit are known for their savvy and understanding of the requirements.
They may only work with businesses that do a good amount of business, and they can limit the countries they deal with to just those that are under their umbrella of knowledge. If you don’t like what your preferred lending institution offers, you can always shop around. Different banks have different required hoops to jump through.
There’s more to the process than just the beneficiary and the buyer. Other people involved in obtaining a letter of credit may include lawyers or legal counsel, who can help ensure your interests are protected by the language in the document. There may also be a handful of banks involved: the negotiating bank (which works on the side of the seller), the confirming bank (which guarantees the funds), the intermediary bank, and the advising bank.
All of these roles may be served by one or two banks, however. The shipper and freight forwarder may also be involved; they could be asked to provide shipping documents as confirmation that terms and conditions were met and that payment should be initiated according to the terms and conditions of the letter.
Letter of Credit Example
There are many banks and financial institutions that offer letters of credit, but they are most common with those that have a solid menu of services for international businesses. Currently, Wells Fargo gives beneficiaries a choice between the commercial letter of credit and the standby letter of credit.
Both of these letters offer:
- Amounts of up to $250,000
- Available for businesses with $2-5 million in annual revenue
- Good for a one-year term with the possibility of renewal
- Has a two-week processing time from date of application
The commercial letter of credit is best for foreign purchases that will be paid after shipment, while the standby letter of credit is used for non-performance in a contract. The funds are secured by deposits made to Wells Fargo.
The lender charges 2%, plus documentation fees paid by the borrower at closing – or 2.5% for amounts below $50,000 – for standby letters of credit. (Fees for commercial letters varies.) Wells Fargo also issues higher amounts through their International Business Department.
Types of Letters of Credit
While we’ve explained the letter of credit, the transaction isn’t always handled the same way each time. In fact, there are a few different variations of the process.
Commercial Letter of Credit
The bank is responsible for payment to the beneficiary. Not only do they guarantee the funds, but they handle the disbursement, as well.
Standby Letter of Credit
This is the opposite of the commercial letter of credit. The buyer (or holder) is responsible for paying the seller (or beneficiary), and the bank only steps in to make payment in the case the buyer can’t. Consider it a backup plan.
Traveler’s Letter of Credit
Going abroad? Take this with you to make sure that the issuing bank will let you take money out at approved banks. Get access to the funds you’re owed, no matter where you go.
Revolving Letter of Credit
If, as the beneficiary, you have an ongoing relationship with a foreign buyer, the revolving letter of credit lets them make purchases again and again, without issuing a new letter for each transaction. Once they pay the letter amount, they can use it again for another purchase. It creates less hassle if you have a long-term series of purchases from the same foreign buyer.
Irrevocable Letter of Credit
As the name suggests, an irrevocable letter of credit (ILOC) cannot be canceled or changed once issued, unless everyone involved says it’s OK. Not even the bank can change the terms and conditions. A revocable letter of credit allows the bank to amend the terms or cancel the letter entirely, without advance notice to the beneficiary.
Confirmed Letter of Credit
Finally, you have a confirmed letter of credit. This happens when two banks are involved on the buyer’s side. The first, or buyer’s bank, is the issuing bank. The second is the seller’s bank – which can make the payment if the buyer and issuing bank don’t follow through. While not as common, it’s something the issuing bank may request.
Letter of Credit vs. Bank Guarantee
While both a bank guarantee and a letter of credit are promises from a bank or lender that ensures a debt will be paid – regardless of whether the buyer or debtor can pay. Letters of credit are most often used in foreign transactions and shipment of goods in the export/import industry. A bank guarantee, on the other hand, is common for foreign and domestic real estate contracts.
One other major difference is that a bank guarantee is considered contractually-binding and used when one of the two parties doesn’t fulfill the terms and conditions of a contract. It helps mitigate risk by ensuring that damages or loss is covered when a contract obligation isn’t kept.
If a contractor delivers materials that aren’t up to the agreed-upon standards, for example, a bank guarantee can come into play. The material-buyer can request payment to help cover any losses at a predetermined rate set forth by the bank guarantee.
If you’re an exporter or looking to get there soon, a letter of credit is a trusted way to get some assurance that you’ll be paid. It can be stressful to wonder if you’ll be taken advantage of, especially when you can’t see your buyer face-to-face and you’re dealing with added factors such as shipping laws and exchange rates. Letting a bank take care of payment frees you up to focus on the things you do best in your business.
This article was originally written on August 19, 2019 and updated on December 10, 2020.