A letter of credit or credit letter is a bank-issued document that guarantees that a seller will receive full payment from a buyer on time. Financial institutions also issue this document in exchange for security or cash. Usually, banks collect a fee that is a percentage of the amount of the credit letter.
It is an essential document while trading internationally. International trade involves aspects like distance, different laws of both countries’ lack of face-to-face contact, and much more. To smooth out this complicated process, a bank issues a credit letter. Read on to know the types, benefits, how to get a letter of credit and more.
There are mainly four types of letters of credit:
Following are the benefits of a letter of credit:
A letter of credit is issued by following the below steps:
Generally, a credit letter is known to help a seller during international trade and exchange. This is because a bank will ensure that seller receives money from the buyer or an issuing bank. However, this monetary document is also beneficial for the buyer when the buyer has already made the payment, and the seller has delayed the shipment. In a situation like this, the buyer will get paid back the money that he or she had spent for making the credit letter.
A seller will have to pay a penalty when the importer receives the refund. Additionally, with the help of a refund, a buyer can now purchase the same products from another party.
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In the case of a credit letter, a bank enters into an agreement with a buyer and a seller. As per this agreement, the bank has to pay money on behalf of the buyer to the seller if the exporter fails to make the payment on time.
Moreover, a bank that issues a credit letter will only issue the document when it has the assurance that the buyer will be able to make payment to the seller. Hence, a buyer has to make a direct payment to the bank.
However, if a seller is unsure that an issuing bank will be unable to make payments in future, then both buyer and the seller need to sign a confirmation letter. In this case, another bank will guarantee for the issuing bank.
While a credit letter is beneficial for buyers and sellers, there are a few disadvantages too. They are as follows:
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A letter of credit helps in minimising all risk factors during international trade and exchange. Moreover, it helps one manage cash flow as an importer does not need to make payments during the initial stages of a deal. Hence, this financial document is beneficial for both importer and exporter.
Ans: Yes, a bank will charge a fee while issuing a credit letter. Typically, most banks charge half per cent of the actual amount that a buyer needs to pay to a seller. Moreover, fees depend on multiple factors like risk amount, etc.
Ans: A bank guarantee is a promise that it will step up if a debtor cannot pay their debts. On the other hand, a credit letter is a financial document that promises that it will pay on behalf of a buyer to a seller if the former fails to make payment.
Ans: The duration of getting a credit letter from a bank depends on the issuing bank. Usually, the approval process takes around 10-15 days. However, the time might increase depending on various factors. Moreover, a bank’s relationship with its client is also a huge factor in getting a credit letter as soon as possible.
Ans: An issuing bank can ask its client for collateral if they have doubts about that client’s finances. One can keep fixed deposits as collateral. That said, the final decision will be of the banks, whether they want to enter into the transaction or not.
Ans: Citibank is well known for offering credit letters to buyers from Africa, Asia, Eastern Europe, Latin America and the Middle East. This is for buyers who have faced problems while obtaining international credit on their own. It helps minimise the importer country’s risk, and it also reduces issuing bank’s commercial credit risk.
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