A letter of credit is a communication from a buyer’s bank to guarantee a supplier payment for goods supplied or services rendered. The letter is mostly used in international trade as a surety that a supplier will receive payment. When the buyer isn’t able to pay in time, their bank must make the payment. These letters have gained popularity because of several factors that govern international trade such as distance and trade laws in different countries.
If faced with a challenge when writing these letters, you can use samples and templates to familiarize yourself on the details and format.
Types of letter of credit
Based on business transactions, various kinds of letters of credit exist. Most common letters of credit include;
A beneficiary can write a letter to transfer payment to another beneficiary or supplier; this letter is a transferable LC. The beneficiary is a link between a seller and the actual supplier. In such a case, the recipient can use their documents as they transfer the money.
The letter doesn’t allow transfer of payment to third parties. It’s only the beneficiary who can claim payment using this letter.
The letter acts as a guarantee for payment. If the buyer does not pay the seller, the bank has to honor the letter by paying the seller.
A revocable letter of credit is a credit letter the issuing bank or the buyer can cancel that without notifying the seller. Such letters are not common since the seller has no guarantee of payment with this letter.
Any changes to this letter can only be made after consultations between the involved parties. This letter guarantees the seller of payment.
Back to Back LC
We use this letter of credit in transactions that involve an intermediary. Back to Back LC involves two letters; one to the intermediary by the buyer’s bank and a second letter to the supplier by the intermediary’s bank.
A second bank writes a confirmed letter of credit to guarantee payment to the seller. The letter cushions the seller from non-payment by the buyer’s bank thus the need for a letter from a second bank confirming payment.
This letter of credit is issued by the buyer’s bank and doesn’t include assurance for payment from a second bank. Most letters of credit fall under this category.
The letter of credit can either be referred to as export or import LC depending on whether an importer or exporter uses it.
A commercial letter of credit is the standard LC and can also be referred to as a documentary credit.
If a single letter of credit is used to cover several transactions, it’s referred to as a revolving letter of credit. Additionally, we can classify revolving credit letters as either value based or time-based.
Deferred payment LC
It’s a credit letter that gives an assurance to the buyer they will receive payment in a stated period. It’s important to note the bank can make payments before the agreed time.
Green clause LC
The letter of credit allows an advance payment of the seller against a receipt, the written undertaking, and proof that the seller has warehoused the goods.
Red clause LC
It’s a credit letter that allows partial payment of the seller even before they ship the goods or offer services.
Direct pay LC
It’s a letter of credit that enables the bank to pay the seller directly and recover the money from the buyer.
It’s a letter of credit that allows the issuing bank to pay the seller if they present the relevant documents as spelled out in the letter.
Sample Credit Letter
Bank letterheadIrrevocable letter of credit
Devatin technologies Ltd
161 East 400 south
Salt Lake City, Utah 84132
Subject: Irrevocable Letter of credit
Name of applicant: …………………..…
Letter of credit number: ………………
Expiry Date: ……………
We write this irrevocable letter of credit in favor of your account for an amount not exceeding$……………………. We have issued this letter of credit following the applicant’s application for [goods or services to pay for].
Availability of funds stated in this letter of credit is subject to drafts drawn on sight and signed by your representative showing a failure by your buyer to make payments for goods/ services rendered as specified in the letter of credit.
The drafts must be in reference to the letter of credit no [………….].
We will honor drafts that comply with this letter of credit and payments made if you present the letter to our offices before or on the stated expiry date.
If we are not informed 30 days before the expiry of this letter of credit, we will automatically renew this letter for another year without any alterations.
This letter of credit is issued under the laws of the state of Utah and international standby practices (ISP98). In case of any conflicts the state, Utah will determine the matter.
Name and signature of issuing bank