To obtain a letter of credit, applicants will often need to work with a specific branch of a bank, such as an international trade department or commercial division. Then - again, like a loan - the applicant waits for approval. The process is similar to applying for a loan, in which an applicant prepares and submits an application (this usually includes the purchase contract, a copy of the purchase order or export contract and a few other documents, depending on the issuing bank). One party will request a letter of credit to be provided to the receiving party.īecause a letter of credit is a document obtained from a bank or other financial institution, the applicant needs to partner with a lender to secure a letter of credit. It is important to understand how a letter of credit operates by design, it starts when two parties have a transactional need. If you think a letter of credit sounds like a fit for your business transaction, the next question to answer is: How does a letter of credit work? How does a letter of credit work? Additionally, several different kinds of letters of credit can cover a variety of scenarios. Several requirements have to be met in order for a business to receive the funds spelled out in a letter of credit.
Accordingly, a letter of credit provides protection for both the buyer and seller: Both parties know that the issuing bank guarantees the payment component of their transaction. They can help an importer or exporter make deals with a greater amount of security and comfort since the business will know they’ll receive payment. Letters of credit are particularly important in international trade.
If the purchaser doesn’t pay on time and in full, the issuing bank underlying the letter of credit guarantees to cover the remainder of the overdue balance up to and including the full amount of the purchase. In a letter of credit, the issuing bank affirms that a purchaser (in this case, a client or a customer) will pay for goods or services on time and for the exact amount due. Importantly, the process involves an impartial third party in the transaction. What’s a letter of credit?Ī letter of credit, also known as a credit letter, is a document from a bank or other financial institution guaranteeing that a specific payment will be made in a business transaction. It’s important to know the letter of credit definition, how a letter of credit works and when you might encounter one during the normal course of business. Although a letter of credit is most commonly used for international transactions, some domestic applications are practical as well. This assurance is particularly important for businesses involved in international trade, imports or exports. In brief, a letter of credit assures business owners that their customers and vendors will pay on time. A handshake or a contract may be an acceptable way of ensuring you’ll get paid in full and on time, but other options, such as a letter of credit, carry more weight. When you run a business, receiving timely payments from customers is critical, whether your clients are domestic, international or both.