Types of Letters of Credit (2024)

What Is a Letter of Credit?

A letter of credit is an assurance or guarantee to sellers that they will be paid for a large transaction. Letters of credit are particularly common in international or foreign exchanges. They act as a form of payment insurance from a financial institutionor another accredited party to the transaction.

The most common types of letters of credit today are commercial letters of credit, standby letters of credit, revocable letters of credit, irrevocable letters of credit, revolving letters of credit, and red clause letters of credit.

Key Takeaways:

  • Letters of credit guarantee sellers that they will be paid for a large transaction.
  • Banks and financial institutions typically take on the responsibility of ensuring that the seller is paid.
  • Such documents are commonly used in international or foreign exchange transactions.
  • Types of letters of credit include commercial letters of credit, standby letters of credit, and revocable letters of credit.
  • Other types of letters of credit are irrevocable letters of credit, revolving letters of credit, and red clause letters of credit.

Types of Letters of Credit (1)

Types of Letters of Credit Depending on Needs

Different types of letters of credit exist to accommodate the diverse needs and preferences of buyers and sellers engaged in international trade. Very broadly speaking, here's why there are different types:

  • Risk Management: Letters of credit are primarily used to mitigate risks associated with international transactions. Different types of letters offer varying levels of risk protection for both buyers and sellers. For example, irrevocable letters of credit provide a higher level of security for sellers, while revocable letters of credit are less secure but may be preferred by buyers seeking more flexibility. Both the buyer and seller can decide on the appropriate letter based on their risk appetite.
  • Flexibility: The different types of letters of credit allow parties to tailor the terms and conditions to suit their specific needs beyond risk as well. For instance, transferable letters of credit are useful when there are multiple parties involved in a transaction. These different types of letters of credit can be used depending on the specific circumstances of the trade to promote efficiency and convenience.
  • Cost Considerations: Different types of letters of credit come with varying costs and fees. Buyers and sellers may choose a particular type of letter of credit based on their budget and the level of financial commitment they are willing to undertake. This notion is especially important to note in relation to the level of risk they're willing to take on (i.e. how much are the buyer or seller willing to spend for incrementally more risk protection?).
  • Regulatory Requirements: Legal and regulatory frameworks governing international trade may influence the choice of the type of letter of credit. For example, some countries or industries may have specific regulations or standards requiring use of specific letters of credit.

Most Common Types of Letters of Credit

Below are some of the more common types of letters of credit. The list is not meant to be exhaustive.

Irrevocable Letter of Credit

In terms of letters of credit, irrevocable letters of credit are more common than revocable ones. These stipulate that no amendments or cancellations can occur without the consent of all parties involved. Irrevocable letters of credit can either be confirmed or unconfirmed. It cannot be modified or revoked without the agreement of all parties involved, offering a high level of security for both the buyer and the seller.

Revocable Letter of Credit

Alternatively, a revocable letter of credit allows the issuing bank to modify or cancel the credit without the consent of the beneficiary. Revocable letters of credit create leverage for the issuer. It is contractually legal for one party to either amend or cancel the exchange at any time, normally without the consent of the beneficiary. These types of letters are not seen very frequently since most beneficiaries do not agree to them, and the UCP has no provision for them.

Confirmed Letter of Credit

A confirmed letter of credit involves the addition of a confirmation by a bank other than the issuing bank, typically the seller's bank. This confirmation serves as a secondary guarantee of payment. This adds an extra layer of security for the seller. The seller can rely not only on the issuing bank's credit but also on the assurance of payment from the confirming bank. This type might be most suitable usually when the beneficiary does not trust the other party's bank.

Unconfirmed Letter of Credit

An unconfirmed letter of credit is only guaranteed by the issuing bank and does not involve confirmation from another bank. While this type of letter may be simpler and less expensive for the buyer, it offers less security for the seller. The seller then has to rely solely on the creditworthiness of the issuing bank which may not be sufficient, especially if the seller is unfamiliar with other the other parties.

Standby Letter of Credit

A standby letters of credit work slightly different thanmost other types of letters of credit. If a transaction fails and one party is not compensated as it should have been, the standby letter is payable when the beneficiary can prove it did not receive what was promised. This is used more as insurance and less as a means of facilitating an exchange. They are commonly used in various scenarios, including construction projects, international trade, and commercial transactions.

Transferable Letter of Credit

A transferable letter of credit allows the seller to transfer all or part of the credit to another party. This flexibility can be beneficial when the seller is unable to fulfill the entire order themselves or when subcontracting certain aspects of the transaction. Transferable letters of credit streamline the payment process and facilitate complex transactions by allowing multiple parties to be involved, such as a small business supplier or construction subcontractor.

Revolving Letter of Credit

A revolving letter of credit is used for multiple shipments over a specified period, allowing the buyer to make multiple drawdowns up to a predetermined limit. This type of letter is useful for ongoing business relationships where there are frequent transactions between the buyer and the seller. An important part here is to realize each party has an ongoing, familiar relationship meaning there is a certain standard of higher trust involved. Revolving letters of credit simplify the payment process by eliminating the need to open a new credit for each shipment meaning they may be more convenient and efficient.

Red Clause Letter of Credit

Red clause letters of credit include a special clause that allow the seller to receive partial payment in advance of shipment. This advance payment, often referred to as a "red clause advance," can be used by the seller to finance the production or purchase of goods for export. This type of letter of credit can give financial assistance to the seller, particularly in situations where they require funds upfront to fulfill the order. For example, consider scenarios where the seller may need to buy specific, rare, expensive raw materials for production of a custom order.

Revolving letters of credit are designed for multiple uses. They can be used for a series of payments. These are common among individuals or businesses that expect to do business together on an ongoing basis. There is usually an expiration date attached to these letters of credit, often one year.

How a Letter of Credit Works

Every letter of credit, regardless of type, is written in an official document agreed to by both parties before it is submitted to the guaranteeing financial institution for review.

Before a letter of credit is acquired for any transaction, both parties must clearly communicate with each other before submitting an application. Both parties must review the terms and conditions on the application and be aware of deadlines, including theexpiration date of the creditand any time allowance granted between the dispatch and presentation.

Although most letters of credit involve international exchange, they can be used to help facilitate any type of trade. Before agreeing to back a letter of credit, afinancial institution is likely to review the applicant's credit history, assets, and liabilities and attempt to find proof that the seller has a legitimate operation.

The buyer oftenhas an existing relationship with the bank. The bank is, therefore, aware of the party's creditworthiness and general financial status. If the buyer is unable to pay the seller, the bank is responsible for making the full payment. If the buyer has made a portion of the payment, the bank is responsible for paying the remainder.

How Do I Get a Letter of Credit?

You can get a letter of credit from your bank, although smaller banks may not offer letters of credit. You will likely have to get a letter of credit through the bank's international trade department or commercial division.

How Much Does a Letter of Credit Cost?

The cost of a letter of credit will vary by bank. Generally it can cost a few percentage points, such as between about 0.75% and 1.5% of the value of the transaction. The amount may be based in part on your credit history.

What Is the Purpose of Letter of Credit?

A letter of credit is used in a business transaction to guarantee that a payment will be made. It is issued by a bank.

The Bottom Line

Letters of credit helps establish that payment will be made in a business transaction. The various types of letters of credit include commercial letters of credit, standby letters of credit, revolving letters of credit and much more.

Types of Letters of Credit (2024)

FAQs

Types of Letters of Credit? ›

The types of letters of credit include a commercial letter of credit, a revolving letter of credit, a traveler's letter of credit, a confirmed letter of credit, and a standby letter of credit. International trade will also sometimes use an unsecured—also called a red clause—letter of credit.

What is letter of credit answer? ›

A Letter of Credit (LC) is a document that guarantees the buyer's payment to the sellers. It is issued by a bank and ensures timely and full payment to the seller. If the buyer is unable to make such a payment, the bank covers the full or the remaining amount on behalf of the buyer.

What is an example of a letter of credit? ›

We hereby authorize you to draw on ourselves for the account of Principle's/Borrower's Name and Service Address up to the aggregate amount of $ Numeric Dollar Amount U. S. funds available by our draft at sight, for the exclusive purpose of securing payment of all utility service (this clause is a requirement for all ...

What is the difference between standby LC and documentary LC? ›

In summary, SBLCs are standby guarantees used as a secondary payment method, LCs are standard financial instruments that guarantee payment upon fulfillment of conditions, and DLCs are LCs that require specific documentation to be presented by the seller for payment.

What are the 4 letters of credit? ›

The types of letters of credit include a commercial letter of credit, a revolving letter of credit, a traveler's letter of credit, a confirmed letter of credit, and a standby letter of credit.

What are the different types of credit? ›

The three main types of credit are revolving credit, installment, and open credit. Credit enables people to purchase goods or services using borrowed money. The lender expects to receive the payment back with extra money (called interest) after a certain amount of time.

What is a standard letter of credit? ›

A letter of credit is essentially a financial contract between a bank, a bank's customer and a beneficiary. Generally issued by an importer's bank, the letter of credit guarantees the beneficiary will be paid once the conditions of the letter of credit have been met.

What are the alternatives to a letter of credit? ›

Aside from trade credit insurance, there are other alternatives to a letter of credit. Those include: Purchase order financing: Purchase order financing provides you cash up front to complete a purchase order. Under this agreement, a financing company pays your supplier for goods you need to fulfill a purchase order.

How much does a letter of credit cost? ›

A buyer will typically pay anywhere between 0.75% and 1.5% of the transaction's value, depending on the locations of the issuing banks. Sellers may find that their fees are structured slightly differently.

Who confirms a letter of credit? ›

A letter of credit is a guarantee from a bank that it will make good on a buyer's financial obligations to a seller in a transaction. A confirmed letter of credit is a guarantee from a second bank that it will pay the seller if the first bank fails to do so.

What is a letter of credit for dummies? ›

A Letter of Credit (LC) can be thought of as a guarantee that is backstopped by the Financial Institution that issues it. One party is required to guarantee something to another party; typically, it's payment, but not always – it could also be guaranteeing that some project will be completed.

Which is better, LC or SBLc? ›

A Standby Letter of Credit is different from a Letter of Credit. An SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party.

What is the red clause in LC? ›

What is a red clause letter of credit? A red clause letter of credit is a form of legal document in payment methods that allows an importer to pay the exporter in advance. Since the importer is confident that the exporter will deliver goods as per schedule, the importer offers to make the payment in advance.

What is the difference between LC and BG? ›

Bank Guarantee vs Letter of Credit

A bank guarantee is a promise made by a lending institution that the bank will step up if a debtor is unable to repay a debt. Letters of credit, which are financial promises made on behalf of one party in a transaction, are particularly important in international trade.

What is the difference between a revocable and irrevocable letter of credit? ›

A revocable letter of credit is uncommon because it can be changed or cancelled by the bank that issued it at any time and for any reason. An irrevocable letter of credit cannot be changed or cancelled unless everyone involved agrees. Irrevocable letters of credit provide more security than revocable ones.

What is the difference between LC and SBLC? ›

A Standby Letter of Credit is different from a Letter of Credit. An SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party.

What is the difference between at sight LC and deferred LC? ›

A Usance Letter of Credit (LC), also known as a Deferred Payment LC, is a type of LC where payment is made at a future date specified in the LC terms. Unlike a Sight LC, where payment is immediate upon presentation of compliant documents, Usance LC allows for a credit period before payment is due.

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