Letter of Credit

Meaning and definition of Letter of Credit

A letter of credit, generally, refers to a letter supplied by the buyer’s bank to the seller after the accomplishment of a contract between a buyer and a seller. This letter of credit from the bank guarantees that the buyer’s payment will be made to the seller on time and for the right amount. If, in any case, the buyer is unable to make payment at the time of purchase, it is required by the bank to cover the full or pending amount of payment.

As stated by Investopedia, letters of credit are generally used in international transactions to guarantee the receipt of payment. The use of letters of credit has become an important aspect of international trade for international dealings include factors like differing laws in each country, distance, and difficulty in knowing each party personally. Moreover, the bank also acts on the behalf of the buyer by guaranteeing that the supplier will not receive payment unless the bank is assured about the shipping of goods.

The Money behind a Letter of Credit

As per a letter of credit, the bank promise to make payments on the behalf of the buyer. But, where does this money come from?

Well, the bank issues a letter of credit only if it is sure about receiving a payment from the buyer. Moreover, some buyers are even supposed to deposit sufficient money to coevr the cost of letter of credit.

How to execute a Letter of Credit

A seller is paid only after performing certain actions which are agreed to by the buyer as well as the seller. For instance, the seller might be required to deliver merchandise to a shipyard so as to satisfy the requirements for the letter of credit. The seller receives a documentation proving the delivery after the goods has been delivered. The letter of credit is now obligatory to be paid even if a mishap occurs to the goods. any mishap occurring to the goods is no more responsibility of the seller.

To make payments on a letter of credit, the bank just reviews documents supporting the seller’s required actions been performed.