What is Letter of Credit?

What is Letter of Credit – The Ultimate FAQ Guide

In this guide, you will find all information you’re looking for about letter of credit.

Remember, this is a useful documentary credit you can use when importing from China.

So, before going for letter of credit, read this guide to get everything right.

What is the Meaning of a Letter of Credit?

A letter of credit can be defined as a document resembling a letter that is issued to the seller to guarantee timely and correct payment of goods or services.

The buyer’s bank is responsible for issuing this document.

In case the buyer fails to meet the payment terms, the bank will be responsible for clearing the payment of the goods.

Over the years, a letter of credit has increasingly be accepted by several traders in international trade owing to factors.

This includes; distance, difficulty in knowing the other party, and different laws in every country.

letter of credit

Letter of credit

What are the Benefits of Using a Letter of Credit?

To begin with, a letter of credit is preferred due to the safety associated with it.

Unlike other methods of payment, the risks are greatly minimized.

A bank is responsible for making the payment and therefore ascertaining the buyer’s creditworthiness doesn’t pose a major threat.

Besides that, let’s have a look at other reasons why a letter of credit is preferred by most importers and exporters;

  • A letter of credit allows the exporters to receive timely payments.
  • Finance is an important aspect for any business to thrive.
  • Timely payments facilitate proper and smooth planning of business affairs.
  • Delivery schedules are well adhered to when using a letter of credit.
  • As compared to other payment methods, the seller might keep on re-adjusting the delivery schedule.
  • This in turn causes inconveniences on the buyer’s side.
  • Letter of credit facilitates the peaceful settling of transaction disputes.
  • All necessary documents that are needed in a letter of credit are outlined thus avoiding any confusion.
  • Because of a letter of credit, an exporter can easily secure pre-order financing.
  • There’s the protection of the buyer in that payment is only made once there’s the fulfillment of the required terms and conditions.
  • An Importer is in control of the shipping dates of purchases being made.
  • The delivery times are well adhered to by the exporter hence efficient operations and planning of his or her business.
  • A letter of credit facilitates the growth of a business.
  • Importers can trade with other foreign importers without worrying about trusting new vendors.

What are the Main Features of a Letter of Credit?

There are five main characteristics possessed by a letter of credit as explained below;

  • Revocability – A Letter of credit can either be revocable or irrevocable.
  • The bak that issues the financial document can decide to revoke a letter of credit anytime without notice.
  • Bear in mind that it’s impossible to confirm a revocable L/C. Additionally.
  • The revocable document is rarely used other than to provide guidelines for shipment.
  • Negotiability –Just as the term implies, letters of credit are negotiable.
  • For it to be negotiable, a letter of credit should make an assurance that it will pay on demand or at a specified time.
  • Transfer and Assignment- Letters of credit that are domestic and administered by the UCC can be transferred as often as you wish without being ineffective.

On the other hand, international letters of credit can only be transferred once.

Only when a letter of credit states that it can be transferred, the seller has no rights to assign the right to draw.

  • Sight and Time Drafts – Letters of credit always require the seller to present the stated documents to receive payment.

A Draft/bill of exchange refers to a written order to a party requesting payment to a third party.

Sight and time are the two types of drafts normally used in letters of credit.

The difference between the two is that a sight draft is payable immediately it’s presented for payment while a time draft is not.

Which Parties are Involved when Using a Letter of Credit

There are 4 main parties namely; the exporter, importer’s bank, an importer, and the exporter’s bank.

Aside from these, other parties that might also be present are not limited to;

  • Discounting bank – Just as the name implies, a discounting bank discounts a draft after acceptance by the accepting bank.
  • Accepting bank – An accepting bank is responsible for honoring the letter of credit and transferring the requested funds to the client.
  • Drawer –In simple terms, the drawer is the party that demands payment. This can either be the exporter or seller of goods.
  • Reimbursing bank – With approval from the issuing bank, reimbursing bank reimburses the drawer bank presenting claims under the letter of credit.

Not only does it apply to the drawer bank but also other banks that submit claims.

  • Applicant – An applicant is the one responsible for opening a letter of credit.
  • In this case, the buyer stands to be the applicant and he or she is required to follow the term and conditions as stated in the purchase order.
  • Issuing bank – Not only does an issuing bank release payment after delivery of documents from the supplier but also takes part in the opening of the L/C.
  • Paying bank – A paying bank can be described as a branch of the issuing bank.
  • Drafts are paid to the paying bank.
  • Drawer bank- This refers to the bank in which the drafts are to be drawn.
  • Negotiating bank – It is the beneficiary’s bank and its role is to certify that the documents meet the terms and conditions stipulated in the letter of credit.

 parties involved in a letter of credit

Parties involved in letter of credit

How Does a Letter of Credit Work?

A buyer’s bank remits a specified amount of money to the seller’s bank once the set terms and conditions are met.

The buyer is required to come up with the terms and conditions under which he would like to purchase the cargo.

This list should contain the following details;

  • Goods description
  • Quantity of goods
  • Documents required
  • Technical description if any
  • Latest shipment date
  • Details of the person who should be notified upon arrival of goods.
  • Mode of transport to be used
  • Type of port pairs to be used.

A letter of credit is sent to the exporter and his or her bank.

The bank of the importer is the one responsible for issuing this document.

Afterward, the exporter’s bank goes through the document to confirm that the submitted document is valid.

Thereafter, the exporter prepares the goods and documents needed which shall be provided once the shipment is done.

His bank counter checks to make sure that the documents are the right ones as per the L/C specifications.

After that, the bank pays the exporter after it is assured that the documents conform to the requirements as outlined in the L/C.

The seller will be paid according to the money agreed upon between her and the importer.

All the documents are then sent to the bank of the buyer for it to confirm all details against the L/C.

Once satisfied, they repay the receiving bank the money that they paid to the sellers.

How Many Categories of Letters of Credit are There?

There are several kinds of letters of credit.

Here are some of the commonly known;

  • Revocable – A revocable L/C can be changed at any time without notifying the beneficiary.
  • An issuing bank is the one responsible for performing such duties.
  • Irrevocable – Unlike the revocable L/C, an irrevocable one cannot be altered unless the parties involved agree to do so.
  • Transferrable –It allows the exporter to carry out credit transfers to another beneficiary either in full or partial.
  • Confirmed –It guarantees payment of goods once the seller meets the requirements of the letter of credit.
  • Back to Back – Back to back involves two L/Cs which are meant to secure financing for one international transaction.
  • Unconfirmed – With an unconfirmed letter of credit, only the issuing bank is responsible for payments and negotiations of the L/C.
  • Fixed- A fixed letter of credit not only has a fixed period but also a fixed amount.
  • Revolving – A revolving letter of credit allows a customer to make multiple transactions up to a certain limit over a longer period.
  • Red clause –A red clause gives an exporter authority to avail the pre-shipment finance.
  • It is normally applicable when the supplier is unable to source goods due to lack of enough funds.
  • Sight- As soon as the goods are delivered with the required documents, a sight letter of credit confirms the payment.

categories of letter of credit

Categories of a letter of credit

Do you Need any Documents when Opening a Letter of Credit?

Yes, you do. Some of the required documents fall under the following categories;

  • Commercial documents
  • Financial documents
  • Shipping and transport documents
  • Official documents required by the importer’s country
  • Insurance documents

Some of these documents are not limited to;

Is a Letter of Credit a Safe Payment Method when Importing from China?

Quite simply, Yes! Many Chinese suppliers prefer using this payment method as it poses no risks to both parties.

A letter of credit is mostly useful when making bulk purchases.

In as much as a letter of credit is quite safe, it also has limitations.

Therefore it’s important to make a wise choice on reasonable grounds before choosing it.

Who Incurs the Cost of a Letter of Credit?

The beneficiary as well as the applicant is responsible for the payment.

The charges might vary depending on the following main factors;

  • The nature of the letter of credit.
  • Pre-existing agreement between the importer and exporter.

How Much Does a Letter of Credit Cost?

Generally, it will cost you 1% of the amount stated in the contract.

For instance, if an importer requires L/C worth $100, 000 .

The letter of credit covers 10% of the contract ($10,000) the importer will need to pay $100 for the L/C.

 Are There Formalities for Opening a Letter of Credit?

The importer’s bank takes the responsibility of opening a letter of credit account on behalf of the applicant.

Opening an L/C account is not much of a hassle.

All you need to do is approach your nearest bank and fill the necessary application forms.

Thereafter, the issuing bank will evaluate the application and approve it.

What do L/C 90 Days Mean?

LC 90 days simply means that the amount of money promised in the letter of credit will be due in 90 days.

Just so you should know, a letter of credit can be LC 90 days, 60 days, or LC 30days.

Both the LC 60 and LC30 days have similar meanings to the LC90 days but with different timelines.

L C Days

L C Days

Can you Verify a Letter of Credit?

Yes, you can verify a letter of credit by checking the factors below;

  • Check the irrevocable structure of the letter of credit and ensure that it’s not stated that the letter of credit is “revocable”.
  • Confirm the date of issue, date of expiry, and the latest date of shipment. Check and verify the following;
  • Ensure that shipment can be made before the latest date of shipment.
  • Confirm if it’s possible to hand over the document before the expiration of the letter of credit.
  • Also, check where the letter of credit expires.
  • Verify the issuing bank and ensure that it’s a valid bank.
  • Ensure that you check the contact and location details of the applicant and beneficiary and confirm that they are correctly stated.
  • Look into the letter of credit currency and the amount and ensure that the amount and currency are correct.
  • Examine the description of the goods and services and check whether it matches the sales contract.
  • Also, ensure that the goods are covered under the commercial invoice.
  • Confirm the documents that are requested by the L/C.
  • The terms that are outlined in a letter of credit should match the sales contract.

How Does Bank Guarantee Vs Letter of Credit Compare?

These two documents are more or less the same in the following ways;

  • Both of them instill confidence in the participating parties.
  • Both assure the third party that the financial institution will pay the goods just in case the borrowing party fails to do so.

On the other hand, they differ from each other owing to the following reasons;

While a letter of credit is concerned about the performance of the transactions of the seller’s credit risk.

A bank guarantee only offers compensation once the buyer defaults.

  • A letter of credit is meant to fulfill the payment once the exporter ships the goods.
  • On the other hand, a bank guarantee is claimed in cases where the buyer fails to accomplish his requirements.
  • While a letter of credit has four main parties (importer, exporter, negotiating bank, and advisory bank).
  • A bank guarantee involves three parties which include; importer, banks, and exporters.

How Should I write a Letter of Credit?

This should not be much of a hassle.

First, you need to stipulate the terms to be followed by both parties.

In case the exporter agrees but fails to meet the set terms, you might be qualified to get some or all of your money back.

Keep in mind that a letter of credit appears to be like instructions and therefore you will only include the basic details.

Some of the details you should include are not limited to the exporter’s details and their receiving bank together with the amount to be transferred.

Lastly, sign the letter to formalize the commencement of the transaction.

What is an Advising Bank in LC?

Once the advising bank gets approval to open the letter of credit; it has the responsibility of informing the exporter.

Normally, this bank is located in the exporter’s country.

It also creates awareness of the conditions of the credit to the exporter.

Keep in mind this same bank can as well act as a notifying bank and a negotiating bank.

What is the Significance of the Advising Bank in L/C Transactions?

Advising bank has significant roles to play in a letter of credit transaction.

Here are some of them;

  • Advises the letter of credit to the exporter.
  • The advising bank verifies that the information/ advice contained in a letter of credit is in line with the terms and conditions of the credit.
  • The advising bank is responsible for scrutinizing the letter of credit.

Advising bank in L C transactions

Advising bank in LC transactions

What is the LC Expiry Date?

LC expiry date refers to the validity period under which the exported documents need to be submitted with bank to negotiate the documents.

The exporter is required to follow the guidelines in the letter of credit as he submits the documents with bank after export.

What is the Difference Between LC Expiry and Shipment Date Expiry?

A shipment date expiry refers to the last date that the goods need to be shipped as agreed upon in the letter of credit.

Alternatively, the LC expiry refers to a specific date on which the letter of credit is expected to be invalid or expired.

The expiry date should not exceed the date of the final disbursement.

Is Telegraphic Transfers the Same as Letter of Credit?

No. These two payment methods differentiate in a manner that;

  • Telegraphic transfer involves the electronic transfer of money from one bank to the other.
  • This happens when you are ready to pay for your goods.
  • Once the money is received, goods can now be shipped and you can sign closing documents during the sale period.
  • A letter of credit is an instruction from the importer to a foreign bank.
  • This helps to pay the exporter once all the conditions in the letter of credit are met.

What are the Disadvantages of Using a Letter of Credit as a Payment Method?

A letter of credit has several advantages but also you need to be aware of a couple of drawbacks associated with this payment method.

Some of these cons are not limited to;

  • It is expensive – All banks charge for their services and the cost can shoot up depending on the features needed by the parties.
  • Both the exporter and importer are required to pay a fee.
  • .Time-consuming- A letter of credit takes time and this can lead to delays and other administrative problems.
  • Keep in mind that it is a conditional payment and making a complying presentation might also be time-consuming.
  • It has sensitive expiration dates.
  • The issuing bank is the one that is dependent on when it comes to making the payments.
  • Currency risk due to the fluctuations in the market.

Can Documents be Dishonored once Submitted?

 What Should be Done if Documents are Dishonored?

Yes, the documents can be dishonored once the beneficiary presents them.

The truth of the matter is that documents can be dishonored when they are found not to comply with the guidelines of the L/C.

In such a situation, below are some of the actions you can choose to take;

  • Correct the document – This is mostly applicable when the shipping company of the beneficiary can correct the discrepancies.
  • This can happen within the presentation of the document period.
  • If it cannot be corrected, negotiation of the draft can be requested by the beneficiary’s bank with permission from the issuing bank.
  • Lastly, the documents can be sent to the issuing bank on “approval “grounds.
  • The documents will need to be sent to the importer only when the importer fails to pay or accept.

What is the Length of Credit Period in a Letter of Credit?

On average, 180 days is the accepted length of credit period in regards to most government regulations.

However, the buyer can decide to either choose number of days between 30  to 180 days depending on his or her preferences.

Is Paying Interest Applicable in a Letter of Credit?

No, it’s not. As a customer, you don’t need to pay any interest.

Keep in mind that your bank will also charge some fees for its services.

What is the Meaning of Advice of Credit?

Once a party requests credit, he or she is issued with advice of credit to confirm that the application request has been approved.

This financial document contains content such as information on how one can extend the credit.

The bank informs the other party that a corresponding bank has opened a letter of credit in his or her favor.

Although most Chinese companies accept letter of credit, they also allow for alternative payment solutions.

For any advice or consultations on how to pay Chinese suppliers, contact BanSar now.

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