What Is a Bank Letter of Credit?

Ken Black

A bank letter of credit is a type of credit product in which a bank guarantees that a sum of money will be paid, provided the agreement stipulated between a buyer and seller is upheld. Typically, individuals may seek out this credit mechanism when conducting a business transaction with an international buyer or seller. This helps ensure the transaction takes place in a legal and forthright way. If the terms of the agreement are not meant by the seller, the money is never exchanged.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

Typically, it is the seller that requests a letter of credit before goods are sent, or services are rendered. When a bank letter of credit is sought, a buyer goes to a bank, usually in his or her own country, and buys the letter of credit. That bank, known as the issuing bank, pays another bank once it ensures the details of the transaction have been completed. The other bank is known as the advising bank and works on behalf of the seller.

Essentially, the issuing bank is putting its reputation and credit worthiness up for a buyer. The buyer may buy the bank letter of credit outright, or may use some type of financing to get the bank's assurance. Once the services or goods are delivered, it is up to the buyer and his or her bank to comply with the details of the agreement for repayment.

To ensure that the products or services are delivered, the issuing bank may require one or more documents. The most common would be a bill of lading, a way bill, or an invoice. These records provide assurance to the institution issuing the bank letter of credit that the agreement has been completed. Typically, a bank employee checks over the agreement and then authorizes a payment to the advising bank.

In order to guarantee that payment is made, the bank letter of credit usually provides an irrevocable payment undertaking, which guarantees a payment no matter what the buyer does. This can only be changed by agreement of the parties, particularly the beneficiary, or seller. As mentioned previously, should the seller not meet his or her commitments, that could affect payment.

Generally, it is larger commercial endeavors that will use a bank letter of credit to move goods and services. For individual transactions, or retail transactions, a personal line of credit is often more convenient, and offers just as many protections for both parties. Therefore, letters of credit will typically involve large amounts of money and merchandise, which can further complicate the arrangement.

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