All you Need to Know About Letters of Credit

In the simplest of terms, letters of credit are documents that guarantee payment from a bank. These letters are mostly used in commercial international trade to guarantee payments between the buyer and seller. These letters insure that if the buyer can’t make the payments for goods or services the bank will honor the exchange of money. With the exacting nature of deals made on the world level, with laws and cultures playing significant roles in finance, a letter backed by a bank has always been a major factor in international trade.

Commercial letters have been used for centuries and are the most trusted form of credit within the international trading community. These insured documents were instrumental in the days of Marco Polo for the evolution of trade and continue today to be a major player in world financing. It is a contractual agreement that replaces the buyer as the payor and makes sure that goods and services are traded fairly on the global market.

How a Letter of Credit Works

Basically, these letters are negotiable instruments that banks issue to pay the named beneficiary. This also makes a letter transferrable as the said beneficiary can transfer the line of credit to another party. Banks usually require some sort of collateral issued against the letter. Banks will also collect a fee for their service, which is usually a percentage of the size of the letter. When it comes to oversight, the International Chamber of Commerce handles matters dealing with international transactions.

When it comes to issuing credit, letters come in three types. Banks usually deal mainly with commercial LCs but some offer revolving LCs which allow a time limit for taking draws against the credit line. A traveler’s LC helps guarantee drafts made from foreign banks. Some banks only guarantee payment in the event the holder of the LC can not honor the purchase. This type of letter is considered a standby LC and is only used when a commercial line of credit is not viable.

It is important to remember that these forms of credit can be complicated and expensive. Ask a financial expert about what options are best for your business when dealing with international trade.

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