What Is Letter of Credit? Definition of Letter of Credit, Letter of Credit Meaning and Concept

Definition of letter of credit is an international means of payment issued by a commercial bank.

Letters of credit are documents issued by commercial banks to guarantee payment for merchandise. This indicates to the seller or exporter that, once the conditions of the contract are fulfilled, the issuing bank is responsible for the disbursement of money.

Characteristics of the letter of credit

Some of the characteristics of letters of credit are:

  • It is one of the most widely used payment methods internationally.
  • It allows to guarantee purchase and sale operations with a high level of reliability. For both the seller and the buyer.
    • The seller assures the collection for his goods or services, after having fulfilled the specifications.
    • The buyer makes sure to pay for what he really needs or specifies in the document. That is, it guarantees the contract under the terms and conditions agreed in the negotiation process.
  • It must contain all the relevant information regarding the purchase and sale agreement. As well as identification of the participants of the agreement.
  • Represents a binding payment commitment by the issuing bank.
  • Failure to comply with what is agreed in a letter of credit, leads to legal measures.

Types of letter of credit

There are several ways to classify letters of credit. Some types of letter of credit are the following:

  • Transferable letter of credit: It is a document that allows the seller to transfer part of the payment. In this case, it can be used to guarantee the supply of raw materials, for example.
  • Confirmed letter of credit: In this case, a bank other than the issuer is involved as guarantor of the contract implicit in the document. Generally, it is the seller's bank that fulfills this function. In this case, it is also called the confirming bank.
  • Letter of credit with advance payment: For this type of contract, there is generally a prior relationship between buyer and seller. The document establishes an advance payment to the seller, prior to the delivery of the merchandise.
  • Deferred letter of credit: In this case, the payment date is established after the delivery of the merchandise with a specific time. It may be the case of contracts in which the buyer requires an inspection of the purchased merchandise.

When to request a letter of credit?

In principle, there must be a negotiation process prior to the issuance of the letter of credit. This agreement must include a contract for the sale of merchandise.

After the negotiation, the seller, to guarantee the payment of their products, requests a letter of credit from the buyer. This, goes to your bank to issue it, after giving you the details of the transaction. If approved, the seller is notified and proceeds to produce or ship the merchandise. Finally, once the conditions established in the letter of credit have been met, the bank makes the payment.

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