A letter of credit is a written agreement about the terms and circumstances of payment for products or services between a buyer, a seller, and one or more banks. A letter of credit is a written agreement about the terms and circumstances of payment for products or services between a buyer, a seller, and one or more banks. It is common practice in international commerce to use letters of credit since they reduce the risk for both the buyer and the supplier.

Definition and Example of a Letter of Credit

Banks serve as neutral third parties to mediate the transaction and provide a payment guarantee if the purchaser does not fulfill their end of the bargain. There are several sorts of letters of credit, each of which offers a unique combination and degree of protection for the parties involved (buyers and sellers). For instance, an exporter who makes a transaction with an importer can ask the importer to pay using a letter of credit rather than traditional payment methods. After that, the importer would secure a letter of credit by collaborating with a bank in their nation. The letter of credit would then be sent from that bank to the bank that serves the exporter in the exporter's nation. Afterward, the exporter would send the products out for shipment per the conditions outlined in the letter of credit. After confirmation from the banks that every requirement has been satisfied, payment is made for the merchandise.

How a Letter of Credit Works

Payment methods such as letters of credit may be quite secure, and they are often advised in circumstances that involve a higher risk, such as the following:

• If the payment conditions are not usual
• If it is a new client
• If the exporter is unable to check the credit of the importer or if the importer has poor credit,
• Because of this, the importer also benefits from the security offered by a credit letter.

Transaction Example

The following is a detailed explanation of how a transaction with a letter of credit is completed:

• When a buyer and seller are situated in separate countries, a letter of credit may be used in the transaction to guarantee that the shipment of the goods and the subsequent payment will go through without a hitch.
• The importer instructs its bank to provide a letter of credit to the exporter as payment.
• The bank first delivers the importer's letter of credit to the exporter's bank, which then delivers it to the exporter.
• The exporter then sends the goods for shipment while providing the necessary papers to the exporter's bank.
• After this, the bank verifies that the exporter has complied with the requirements stipulated in the letter of credit by determining whether or not the exporter has met its responsibilities.
• The exporter's bank negotiates the terms of payment with the importer's bank and then transfers those funds to the exporter's bank.
• The importer will pay the bank for the items, at which point the bank will deliver the necessary papers for the importer to claim the merchandise and get them through customs.

Different Varieties of Credit Letters

A few distinct varieties of letters of credit may be obtained. The following are some of the characteristics that are shared by all of these letters:

Sight or Term

This decides whether or not the seller is paid as soon as they provide all of the relevant paperwork, which is referred to as a sight letter of credit. Or at a different period specified in the sales contract—a term letter of credit, often known as a "usance" letter of credit.

Revocable or Irrevocable

Revocable letters of credit allow the issuing bank to revoke or alter the terms of the letter of credit at any time without first informing the seller. The vast majority of letters of credit are irreversible, which means that the terms of the contract cannot be altered or canceled without the consent of all parties concerned.

Confirmed or Unconfirmed

When a buyer's bank permits another bank operating in the seller's business site to confirm the transaction, this is known as a confirmed letter of credit. It is an extra layer of protection, ensuring that the seller will be compensated by the bank in the seller's location if the buyer's bank defaults. It is common practice in international commerce to use letters of credit since they reduce the risk for both the buyer and the supplier. On the other hand, a non-confirmed letter of credit does not have a bank located in the same region as the seller to operate as a safeguard for the transaction.