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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.