Letters of Credit LC: Full Form, Meaning, Types, Costs, Benefits & How to Apply

As soon as the buyer receives the goods or service, the seller encashes the LC. A letter of Credit (LC) is a legal document backed and issued by the bank. Therefore, it is an essential piece of paper for the reliable export and import of products or services. It ensures that both the buyer and the seller fulfill the commitments stated in the sales contract.

• It serves as a safeguard in international and domestic trade, ensuring both parties fulfill their obligations.
• Letters of Credit are one of the most secure payment instruments available but can be labor-intensive and relatively expensive due to bank fees.
• Depending on the terms of your negotiations, a letter of credit issued by a buyer’s bank can come with a 90, 60, or 30 day term.
• A letter of Credit (LC) is a legal document backed and issued by the bank.
• A letter of credit is a financial document issued by a bank or financial institution that guarantees payment to a seller on behalf of the buyer, as long as specific conditions outlined in the document are met.

Accommodating Various Types of Trade Transactions

Once the letter of credit has been received by the seller’s bank, the seller can apply with his bank for a second letter of credit of a lesser value. This second letter of credit is sent to the third-party supplier’s bank so that the supplier knows that he or she will be paid and can proceed with that part of the transaction. Back-to-back letters of credit are typically used when a seller has to purchase a component or subcontract part of the manufacturing of a product to a third party, but does not have the cash flow to do so. Letters of credit are used to minimize risk in international trade transactions where the buyer and the seller may not know one another. The issuing bank offers the LC in favor of the seller in exchange for a specific fee. The issuing bank releases the payment when the seller delivers the goods consignment or services to the buyer.

In international trade, letters of credit are used to signify that a payment will be made to the seller on time and in full, as guaranteed by a bank or financial institution. After sending a letter of credit, the bank will charge a fee, typically a percentage of the letter of credit, in addition to requiring collateral from the buyer. There are various types of letters of credit, including revolving, commercial, and confirmed. A Letter of Credit (LC), often called LC, is a financial document issued by a bank or financial institution that guarantees the buyer’s payment to the seller in a business transaction. It serves as a secure method of ensuring that the seller receives payment for goods or services provided. In simple terms, a letter of credit (LC) is a promise to pay that’s backed by a financial institution and a valuable part of trade finance.

This ensures that the seller gets paid and that there are no complications between buyer and seller. 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 the expiration date of the credit and any time allowance granted between the dispatch and presentation.

Documents Required for a Letter of Credit

• This provides the buyer with a credit period, helping them manage cash flow while assuring the seller of payment.
• A letter of credit issued by a buyer’s bank in a different country can and should help clarify the rates of exchange and payment expectations for the foreign market with which you may not be familiar.
• It is an intermediary letter of credit issued for the non-disruption of the trading services.
• For example, consider scenarios where the seller may need to buy specific, rare, expensive raw materials for production of a custom order.

This allows the parties to choose terms that best suit their financial needs. Therefore, LC remains a cornerstone of international trade financing, serving as a key element supporting the smooth and secure flow of goods and services in the global market. Additionally, a Letter of Credit can be used in both international and domestic trade transactions. Thus, with these benefits, utilizing an LC can help provide a consistent and reliable mechanism to facilitate payments in various jurisdictions. Therefore, it is crucial to understand LC and know how to obtain and use it to support cross-border business.

Access and download collection of free Templates to help power your productivity and performance. Like a Financial Letter of Credit, the Issuing Bank needs funds available immediately if the LC gets called. In this case, what is the meaning of letter of credit Standby LCs are similar in that they too often require some kind of highly liquid collateral, such as cash or a “carve out” from the borrower’s operating line of credit. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

How Much Do Letters of Credit Cost?

This is the type of LC where payment is given against documents on presentation. Since the Issuing Bank is required to actually remit payment when the LC is called, they need to have something highly liquid available. As a result, the applicant will generally either post cash collateral to backstop the LC, or management may be able to “carve out” a portion of its operating line of credit instead. However, like anything else related to banking, trade, and business, there are some pros and cons to acknowledge. CAs, experts and businesses can get GST ready with Clear GST software & certification course. Our GST Software helps CAs, tax experts & business to manage returns & invoices in an easy manner.

If, for some reason, the customer or buyer (also known as the “applicant”) can’t come up with the money, the bank still has to make good on their guarantee to the seller. This provides assurance to the exporter that they will receive payment for their goods or services, reducing the risk of non-payment and fostering trust among trading parties. When a buyer requests a letter of credit from their bank, they are essentially asking the bank to promise to pay the seller a specific amount of money. This promise is contingent upon the seller providing certain documents, like shipping receipts or invoices, within a set timeframe. This process helps build trust between the buyer and seller, especially in international transactions where parties may not know each other well.

It is a commonly adopted practice in international trade when there is substantial geographical distance or a lack of trust among the parties. Financial LCs are intended as a method of payment, albeit one managed and overseen by financial institutions instead of the individual trading partners. This arrangement is vital in overcoming challenges inherent in international dealings, such as differing national laws and the geographical distance between trading parties. As a result, letters of credit are indispensable in protecting both buyers and sellers from potential risks during trade. A Letter of Credit is a contractual commitment by the foreign buyer’s bank to pay once the exporter ships the goods and presents the required documentation to the exporter’s bank as proof. In the case of large international transactions of tangible goods, a freight forwarder is in charge of the physical transport of the assets in question.