When you import goods from abroad, you might worry that your supplier will disappear with your product and your money after payment goes through. The best way to secure your interest is by signing a letter of credit. It is a financial contract between three parties: the importer, the exporter, and the bank.
Letter of credit – what is it?
A letter of credit (L/C) is a financial document in which the bank guarantees that a particular amount of money will be paid to the exporter’s bank account on behalf of the importer as long as the seller delivers the ordered products on time and according to other agreed conditions.
How does a letter of credit work?
The procedure for the letter of credit looks like this:
- After the involved parties sign a contract, the importer applies to their bank to open a letter of credit in favor of the exporter.
- The bank processes the request – it is important to note that they don’t have to accept it. They verify the company, the terms of the contract, and whether it is possible to fulfill. If their decision is positive, the terms for opening the letter of credit are determined. It should take between 1-3 days.
- The importer’s bank prepares the draft of the letter of credit and transmits it to the exporter’s bank, where it is reviewed. If it is approved, it is further passed to the exporter.
- After the ordered goods shipment is made, the exporter prepares the documents necessary to prove that it was conducted according to the agreed conditions.
- The exporter’s bank checks the documents. In case there are some errors or missing elements, they inform the exporter to make necessary changes. When the documents are complete and approved, the exporter’s bank submits them to the importer’s bank.
- If no faults are found in the documents, the importer’s bank releases the payment to the exporter’s bank.
It is important to note that the bank participating in the letter of credit releases the payment based on the provided documentation; they don’t inspect delivered goods.
What documents do you need to prepare for a letter of credit?
Documents that are usually reviewed by banks (the involved side can decide what documents the seller will have to provide):
- Commercial Invoice
- Bill of Lading or Air Waybill
- Insurance Certificate
- Certificate of Origin
- Packing List
- Certificate of Inspection
The role of banks in the letter of credit
The bank that is a part of the letter of credit affirms that the payment for ordered goods will be made. Even if the importer, for some reason, is unable to pay, the issuing bank will cover the amount that was lacking. However, it also serves as a third party to which an exporter has to provide documents proving that the order has been carried out successfully and according to an agreement. Therefore, the involvement of the bank in the letter of credit makes business transactions safer and takes off some of the stress that may accompany them, especially international deals.
Types of letters of credit
There are a few kinds of letters of credit that you may choose from depending on what you and your supplier agreed on:
Irrevocable letter of credit
Irrevocable L/C cannot be amended or canceled without the consent of all involved parties; it is the most commonly used type.
Revocable letter of credit
Revocable L/C gives the importer’s bank the right to alternate or cancel the letter of credit without informing the beneficiary.
Stand-by letter of credit
Stand-by letter L/C guarantees that the bank will cover the payment if the beneficiary doesn’t receive payment and can prove that he wasn’t compensated.
Confirmed letter of credit
Confirmed L/C requires that another financial institution (for example, the exporter’s bank or another bank in their home country) guarantees that the payment will be made; it is usually used if the exporter isn’t familiar with the importer’s bank and doesn’t have much trust in it. If the importer’s bank fails to cover the payment, the second bank will do it.
Unconfirmed letter of credit
Unconfirmed L/C states that only the issuing bank will be responsible for payment.
Transferable letter of credit
Transferable L/C allows the beneficiary to assign part of his rights to third parties – it is especially useful if the seller isn’t the only manufacturer, so the importer doesn’t have to open multiple letters of credit.
Back-to-back letter of credit
Back-to-back L/C involves two letters of credit – one connecting the buyer and intermediary and the second between the intermediary and seller.
Payment at sight letter of credit
Payment at sight L/C is the fastest type; the payment is made immediately upon presentation of necessary documents by the exporter and their review by the bank.
Deferred payment letter of credit
Deferred payment L/C states that the parties have agreed on some time period that has to pass before the payment is made. This kind of letter of credit may give the importer time to, for example, inspect the goods after the delivery.
Red clause letter of credit
Red clause L/C states that the payment will usually be made in advance, so the seller can use that money to pay for materials or cover production and shipment expenses.
How much does a letter of credit cost?
There is no universal price for this kind of service. Usually, the banks charge a percentage of the total amount of credit that will be paid, so the price will vary depending on the bank and the size of the credit.
The costs of opening the letter of credit that you will have to pay also depend on which kind of it you decide on, as some types may have higher fees than others.
Should you use the letter of credit?
If you make a deal with a new trading partner, especially one that is located far away from your location, it would be advisable to use a letter of credit. You should also consider it if you have any doubts about your supplier’s reliability or accountability. The letter of credit should also be taken into consideration if you make a big shipment, where any error may cause you significant financial loss.
The letter of credit can minimize the risks for sides participating in business transactions. However, it cannot eliminate them completely – complications such as bank failure, legal disputes, or unstable currency may still happen.
L/C – benefits for importers
- It ensures that the order will be delivered on time
- It ensures the quality of delivered goods (if the letter of credit includes a list of necessary certificates). The letter of credit may also include the list of documents that need to be provided before the payment is released
- It protects the importer from financial losses as the bank releases the payment only after the order has been shipped and its documents have been checked
L/C – benefits for exporters
- It ensures the supplier that he will receive payment and will receive it on time, even if the importer is unable to fulfill his obligations
- It guarantees that the importer won’t withdraw from the contract
- As it includes the list of required certificates and other documents concerning the ordered goods, the exporter doesn’t have to worry that the importer will try to change the product’s specification
Letter of credit – summary
- Letter of credit is a financial document involving the importer, exporter, and their respective banks.
- The aim of a letter of credit is to ensure that the exporter delivers the ordered goods on time and in the required condition and receives payment without issues.
- Letter of credit is advisable for transactions between new trading partners, for big shipments, and if there are any doubts about the supplier’s reliability.
- Letter of credit isn’t the cheapest option, but thanks to the involvement of banks, it has an additional protection layer for the interests of both sides involved.