Understanding Letter of Credit and How It Works

Understanding Letter of Credit and How It Works

Trading with foreign businesses or engaging in commercial transactions with unknown people can result in significant losses. For instance, the items may not be relayed, or the vendor may fail to pay as planned. Traders utilize letters of credit to safeguard themselves against such problems. A basic letter of credit ensures security and peace of mind for the buyer by guaranteeing payment to the supplier when the items are received.

The Purpose of a Letter of Credit

The issuer of the letter of credit, the payor, and the recipient is usually the parties involved in a letter of credit. A letter of credit, which is a sort of upfront memorandum of understanding for funding, allows a seller to decide the exact price that will be earned from the letter of credit’s issuer. A creditor can also utilize a letter of credit to guarantee that the document’s originator will pay the creditor’s drafts according to the terms of the agreement.

Types of Letters of Credit

Letters of credit are generally flexible financial assets that are tailored to the needs of all parties involved in a contract.

The major payment method is a commercial letter of credit, which reimburses irrespective of whether the buyer has the financial resources to pay. While a standby letter of credit is a backup payment method in which the financial institution pays the recipient only if the buyer is unable to do so.

Lastly, a recurring letter of credit enables the client to make as many withdrawals as he or she wants within a particular time frame, subject to a restriction. Another bank usually the seller’s bank endorses a verified letter of credit, ensuring payment if both the holder and the issuing bank default.

General Procedure

The buyer and seller agree to do business, which makes the seller need a letter of credit from the buyer to guarantee payment. If the bank approves the buyer’s risk, it will provide a letter of credit to the seller’s bank.

Thereafter, the seller will send the products and produce and submit the appropriate paperwork to his bank for payment processing after his bank has notified him about the letter. The bank will then check the paperwork for conformity with the letter of credit’s terms, criteria, and specifications. Once this is confirmed, the seller’s bank will debit the buyer’s bank account.

Expenses and Collateral

Although the issuing bank will agree to pay in the buyer’s name, the buyer must demonstrate the ability to fund the letter of credit. The bank may demand the buyer to deposit sufficient funds to support the letter of credit or to use the issuing bank’s line of credit. The buyer is responsible for all fees. The amount owed and the time it will take for the buyer to get the products are used to calculate the interest rate and the terms must be agreed upon by all three parties.

Return Earnings

A precise time frame will be specified on the letter of credit, indicating when the products must be delivered or payment must be made. If items are delivered but payment is not received by the deadline, the seller will earn additional interest as indicated in the letter of credit. Similarly, if the seller fails to fulfill the agreed-upon deadline and shipment is stalled, the buyer may be entitled to rebates or interest refunds, contingent on the contractual terms.

The Rule of Independence

According to experts, the success of letters of credit is based on inherent autonomy. Once the products are in hand, the originator of a letter of credit, or the issuing bank, must pay the seller.

Even if the buyer is unhappy with the items, the bank’s primary interest is to follow the letter of credit’s provisions to the full extent, leaving any other contractual issues between the buyer and the seller, as this has no bearing on its agreement to pay the seller.


Banks, as issuers, frequently employ uniformed formats for letters of credit, including deciding the tenure, which can be as long as the issuer specifies. Also, the maximum amount of money is usually specified in the contract, such that when the customer pays the total amount due, whether it be in tranches or one single payment, the letter of credit validity is expired.

Fees for Commercial Letter of Credit

A standard commercial LC contract includes multiple fees and offers a guarantee for a specific period, usually four months. The supplier covers some fees, while the customer pays others. A typical buyer’s cost for LCs above $100,000 is 0.75 percent, but it can vary from 1.5 percent in developing countries.

The seller’s total expenses will most likely be lower, but there could be 5 to 10 distinct charges for mailing, delivery companies, bank-to-bank repayment charges, validating the LC, and other services, each ranging from $25 to $150.

The Author

Oladotun Olayemi

Dotun is a financial enthusiast who specializes in first-in-class financial content, including crypto, blockchain, market, and business, to educate and inform readers.