Letter of Credit: A Complete Guide

When two businesses from different countries trade, trust becomes a big issue. The buyer fears paying and not receiving the goods, while the seller fears shipping goods and not getting paid.

A Letter of Credit (LC) solves this problem. It’s a financial guarantee issued by a bank, promising that the seller will be paid once certain conditions are met. This tool is widely used in international trade, giving both buyers and sellers the confidence to do business safely.

If you’re exploring global trade or simply curious about how companies manage large transactions, understanding how a letter of credit works can help you see why it’s such an important instrument.

What is a Letter of Credit?

A letter of credit is a document issued by a bank that guarantees payment from the buyer to the seller. The bank acts as a middleman, making sure the seller only gets paid once they meet the terms in the LC, like shipping goods and presenting correct documents.

• Buyer requests the LC from their bank.

• Seller ships goods and submits required documents.

• Bank verifies documents and releases payment to the seller.

This structure protects both sides. The buyer knows they won’t pay unless goods are shipped properly, and the seller knows they’ll receive payment if they follow the rules.

Why Are Letters of Credit Important?

Letters of credit are essential in international trade because of the risks involved. Buyers and sellers are often located in different countries, with different laws and no easy way to resolve disputes.

• Trust building – Reduces risk for both sides.

• Smooth trade – Encourages cross-border deals.

• Assurance of payment – Sellers feel secure shipping goods overseas.

• Reduced fraud – Strict documentation lowers chances of scams.

Without LCs, many international deals might never happen, especially between partners who don’t know each other well.

How Does a Letter of Credit Work Step by Step?

Here’s a simple flow of how an LC works:

1. Buyer and seller agree to use an LC for payment.

2. Buyer applies for an LC from their bank.

3. The bank issues the LC and sends it to the seller’s bank.

4. Seller ships goods and submits documents (invoice, bill of lading, insurance, etc.).

5. Bank reviews the documents.

6. If everything matches, payment is released to the seller.

This structured process ensures both payment and delivery happen fairly.

Types of Letters of Credit

There are different types of LCs designed for specific needs:

• Revocable and Irrevocable – Most are irrevocable, meaning they can’t be changed without agreement.

• Confirmed LC – Another bank guarantees payment in addition to the issuing bank.

• Sight LC – Payment is made immediately once documents are verified.

• Usance LC – Payment is made after a certain time, like 30 or 60 days.

• Standby LC – Acts as a backup in case of non-payment.

Each type serves a different purpose depending on the trade deal.

Benefits of Using a Letter of Credit

Letters of credit offer several advantages to both buyers and sellers:

• Risk reduction – Banks ensure conditions are met before payment.

• Access to new markets – Companies can trade globally with more confidence.

• Financial security – Sellers are assured of receiving money.

• Flexibility – Many types of LCs exist to fit different deals.

This makes them one of the most trusted tools in trade finance.

Risks and Limitations of Letters of Credit

While useful, LCs also come with some challenges:

• Cost – Banks charge fees that can be high for smaller businesses.

• Complex documentation – One mistake in paperwork can delay payment.

• Time-consuming – The process requires checks, which can slow transactions.

• Bank risk – If the issuing bank is weak or unstable, there’s still a chance of default.

So, while they reduce risk, they don’t eliminate it completely.

Real-Life Example of a Letter of Credit

Imagine an exporter in India is shipping textiles to a buyer in the U.S. The buyer’s bank issues a letter of credit guaranteeing payment once the exporter provides shipping documents. The exporter ships the goods, submits the documents, and the bank releases payment. Both sides get what they want: the buyer gets goods, and the seller gets paid.

Conclusion

A letter of credit is more than just paperwork—it’s a bridge of trust between buyers and sellers in international trade. By using a bank as a guarantor, it ensures sellers receive payment and buyers get the goods they paid for.

While costs and documentation can be a challenge, the benefits far outweigh the risks. For businesses looking to expand globally, LCs are a vital tool.

FAQs

What is a letter of credit in simple terms?

A letter of credit is a guarantee from a bank that a seller will be paid as long as they meet the agreed conditions. It protects the seller from non-payment and assures the buyer that payment will only be made when proper documents, like shipping records, are presented and verified by the bank.

Who uses letters of credit?

Letters of credit are mainly used in international trade where buyers and sellers don’t fully trust each other. Exporters, importers, and banks all rely on LCs to reduce risks. Even small businesses use them when entering new global markets, ensuring safe payments and deliveries without depending solely on personal trust or unknown partners.

What documents are required for a letter of credit?

The documents usually include the commercial invoice, bill of lading, packing list, insurance certificate, and sometimes inspection certificates. These documents prove that goods were shipped as agreed. If they match the LC’s terms exactly, the bank will release payment. Any errors or mismatches can delay or block payment until corrected properly.

What are the main types of letters of credit?

The main types include sight letters of credit, usance (deferred payment), standby LCs, and confirmed LCs. Sight LCs pay immediately after documents are checked, while usance LCs allow payment after a set period. Standby LCs serve as a backup in case of non-payment, and confirmed LCs carry an additional guarantee from another bank.

What are the risks of using letters of credit?

The biggest risks are cost, errors in documents, and reliance on banks. Fees can be high for small firms, and one minor paperwork mistake can block payment. There’s also the risk of the issuing bank defaulting if it’s not financially strong. While LCs reduce trade risks, they don’t completely eliminate every possible problem.