Letter of Credit: Definition, Types, and Process
Letter of Credit has become a very important tool in international dealings to mitigate risk for both parties. A letter of credit also known as LC is a financial tool ensuring that the seller will receive the Payment on time. In any case, if the buyer refuses to pay the bill then the bank covers the remaining bill amount. It is very important tool because of the uncertainty in the international business environment. letter of credit is one of the easiest ways to build trust in international businesses.
How a Letter of Credit Works-
- It is issued by a bank to ensure the payment guarantee to the seller if the conditions specified in the letter are met. To issue the LC the buyer requests the bank to issue and also specifies the the terms and conditions. Then the bank requires some proofs regarding the shipping and related invoices.
- This is a negotiable financial instrument which can be paid to the beneficiary or any bank appointed by the beneficiary. This mitigates the risks of payment default international trade. You can also use a letter of credit to take a business loan.
Key Considerations Before Applying for a Letter of Credit-
- Letter of Credit is one of the best methods of payment. But it can be costly because of the bank fees and other charges.
- It can also be time-consuming because of the verification and other extra steps.
- You should also check the costs with the different Letters of Credit providers.
- Carefully review the terms, including delivery dates, payment deadlines, and required documents to avoid misunderstandings or rejected payments.
- Be aware of the processing time which can impact the overall timing of your transaction.
Types of Letter of Credit in India
1. Transferable Credit –
The rights of this can be transferred to other beneficiary. This is commonly required in industries where one or more third parties are involved. This type of credit ensures the complex supply chain transfers on time.
2. Revocable Letter of Credit (LC) –
Revocable Letter of Credit can be amended or canceled by the issuing bank without any prior notice or content from the beneficiary party. This feature of this credit makes it less secure for the beneficiary. That is why it is rarely used in modern trade financing. They are only suited if the seller and buyer have a high degree of trust.
3. Credit on Sight –
It is a type of payment that ensures immediate payment after presenting the required documents. Upon presenting the documents the bank reviews the documents and then checks if everything is in order then releases the payment immediately. It is one of the most instant Letter of Credit.
4. Time Credit –
Time credit is a type of credit that does not allow the beneficiary to withdraw cash immediately. Usually, they are paid after a specific period such as 30, 60, or 90 days after receiving goods. It helps the borrower to buy some time to arrange funds after the trade delivery is completed.
5. Irrevocable Credit –
Once the Irrevocable Credit is issued then its condition and terms can not be changed or amended by the issuing bank. To make these changes all parties need to be involved. This Letter of Credit provides a form of commitment and security to the exporter. Some banks may accept irrevocable Credit as collateral to give you loans such as Working Capital Loan, Import Financing, and Term Loan.
6. Standby Letter of Credit-
Standby Letter of Credit acts as the safety net if the buyer fails to complete the payment. In the Letter of Credit arrangement, if the buyer fails then the bank guarantees the payment to the seller. It is used for the low-trust relationship between the buyer and seller.
Total Cost for the Letter of Credit-
Letter of Credit attracts many types of fees which can be Issuance Fee, Advising Fee, Confirmation Fee, Negotiation or Discounting Fee, Reimbursement Fee, and many others. All of these fees can be from 0.5% to 3% of the total value of the Letter of Credit. It also depends on the type of Letter of Credit for example unconfirmed letter of credit costs less than a confirmed Letter of Credit because it involves only one bank’s commitment.
Advantages and Disadvantages of a Letter of Credit-
- Letter of Credit benefits the involved parties by mitigating risk and providing payment assurance. They help the trades to manage the supply chain payments effectively. Letter of Credit also helps the business to overcome the hurdles in the international trade.
- Letter of Credit increases the overall value of the by adding various charges and fees. It is very high time-consuming and and complex process. It does not offer flexibility to the seller after the terms of the Letter of Credit are finalized.
Difference between the Letter of Credit and Bank loan-
A Bank loan involves borrowing money from a bank while a Letter of Credit is a guarantee from the bank to the seller. The letter of credit does not involve the repayment while the bank loan has specific repayment terms. In short bank loan is a debt agreement, while a Letter of Credit is a guarantee of payment.
How to apply for a Letter of Credit-
- The buyer goes to the desired bank to apply for the Letter of Credit.
- Then the issuer bank checks the authenticity of the deal and conforms to the other details.
- Then the bank drafts the letter of credit based on the terms and conditions. Then the letter is sent to the exporter’s bank. Later it is sent to the exporter after verifying.
- Then the exporter ships the goods and services and sends the documents to the bank.
- Then the receiver bank verifies the details based on the Letter of Credit.
- After this process is complete then the bank sends the necessary documents to the importer’s bank.
- In the end, the bank releases the payment to the payment to the exporter.
Letter of Credit Example:
For example ICICI Bank and HDFC Bank both offer letters of credit. You can apply for a Letter of Credit from ICICI Bank digitally through their website. They also offer the facility to avail Letter of Credit against Fixed Deposits.
Conclusion:
A Letter of credit is an essential tool in trade for risk management and ensures that both parties involved must fulfill their obligations. Before applying for the Letter of Credit you should understand your requirements and processing times to avoid unexpected challenges. You can leverage a Letter of Credit to enhance your credibility and build better business relationships whether you are an importer or exporter.
ALSO READ: Working Capital Loan: Types, Benefits, and Importance
