What are Some Uses for a Letter of Credit?

Malcolm Tatum

Many companies and individuals have an established letter of credit. Essentially, a letter of credit is the amount of credit that a lender is willing to extend to a borrower over a period of time, based on the financial stability of the borrower. In some cases, a letter of credit involves the establishment of a loan that is extended by a financial institution for a specific purpose, with some sort of payments expected along the way. At other times, the structure of the letter of credit is not tied to specific purpose, with the credit being open to use as the borrower sees fit. Here are some examples of the more common forms of a line of credit, and what types of commitments are expected on the part of the borrower.

Businessman giving a thumbs-up
Businessman giving a thumbs-up

Perhaps the single most common example of a letter of credit is the provisioning of a credit card to an individual or company. Generally, a credit card is extended with a limit on the amount of credit that the cardholder may employ. In return for accepting the card and the privilege of using the card at will, the card holder agrees to make at least regular minimum payments on the outstanding balance, as well as keep the total balance due on the account below the fixed credit limit. The issuer of the card charges interest on the unpaid balance, and retains the right of increasing the rate of interest in the case of late payments, as well as revoking credit privileges if the line of credit is abused. When the financial institution chooses to raise the credit limit, a new letter of credit is created and applied to the account.

Along with credit cards, consumers may also apply for letters of credit from banks and other lending institutions. This is often helpful when anticipating a major purchase, such as a home or new vehicle. By arranging for a letter of credit in advance, the consumer is free to look at home and car options that are available within the approved maximum amount extended. This allows the consumer to close the deal quickly, and begin the process of repaying the bank according to the terms of the credit agreement.

This form of credit line is sometimes referred to as documentary credit, as the offer of credit is extended before the purchase is made. As a bonus, the consumer already knows the payment schedule and the maximum amount of each payment in advance of making the purchase, so it is easy to determine whether or not the monthly budget is capable of honoring the commitment to pay.

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