We are independent & ad-supported. We may earn a commission for purchases made through our links.
Advertiser Disclosure
Our website is an independent, advertising-supported platform. We provide our content free of charge to our readers, and to keep it that way, we rely on revenue generated through advertisements and affiliate partnerships. This means that when you click on certain links on our site and make a purchase, we may earn a commission. Learn more.
How We Make Money
We sustain our operations through affiliate commissions and advertising. If you click on an affiliate link and make a purchase, we may receive a commission from the merchant at no additional cost to you. We also display advertisements on our website, which help generate revenue to support our work and keep our content free for readers. Our editorial team operates independently of our advertising and affiliate partnerships to ensure that our content remains unbiased and focused on providing you with the best information and recommendations based on thorough research and honest evaluations. To remain transparent, we’ve provided a list of our current affiliate partners here.
Finance

Our Promise to you

Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content. Our dedication to quality remains unwavering—and will never change. We follow a strict editorial policy, ensuring that our content is authored by highly qualified professionals and edited by subject matter experts. This guarantees that everything we publish is objective, accurate, and trustworthy.

Over the years, we've refined our approach to cover a wide range of topics, providing readers with reliable and practical advice to enhance their knowledge and skills. That's why millions of readers turn to us each year. Join us in celebrating the joy of learning, guided by standards you can trust.

What is a Letter of Credit?

By O. Wallace
Updated: May 16, 2024

A letter of credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank is required to cover the full or remaining amount of the purchase. A letter of credit is often abbreviated as LOC or LC, and is also referred to as a documentary credit. The parties to this document are usually an applicant who wants to send money, a beneficiary who will receive the money, the issuing bank, and the advising bank.

International transactions often use letters of credit to ensure that payment will be received. They have become an important aspect of international trade, due to differing laws in each country and the difficulty of knowing each party personally. The bank also acts on behalf of the buyer, or holder of the letter, by ensuring that the supplier will not be paid until the bank receives confirmation that the goods have been shipped.

A letter of credit is often confused with a bank guarantee, which is similar in many ways but not the same thing. The main difference is the bank's position relative to the buyer and seller of a good or service in the event of the buyer's default of payment. With a letter of credit, seller may request that a buyer provide them with a letter obtained from a bank that substitutes the bank's credit for their client's.

In the event of the borrower defaulting, the seller can go to the buyer's bank for the payment. Instead of the risk that the buyer will not pay, the seller only faces the risk that the bank will be unable to pay, which is unlikely. This means that, if the applicant obtaining the letter fails to perform his or her obligations, the bank must pay. The letter can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming it. This type of guarantee is less risky for the merchant, but riskier for a bank.

SmartCapitalMind is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
Discussion Comments
By anon64541 — On Feb 08, 2010

what is CDCS certification?

By anon54140 — On Nov 27, 2009

Yes, you need to have a good credit worthiness to apply for LC. Why should the bank take a risk on you?

By anon33753 — On Jun 11, 2009

What is the impact on the company if neither of the letters of credits can be cashed?

By mitsmania — On Apr 07, 2009

1)Is the Purchase order document necessary for the importer to raise a letter of credit?

2) Does the format for various letters of credit differ? (eg: for revocable it is different and irrevocable it is something else).

By anon20546 — On Nov 02, 2008

Do you need good credit to apply for a Letter of Credit?

Share
SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.

SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.