Letter of Credit: What It Is and How It Works

Updated on September 8, 2020
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When you’re a small business owner, there are a variety of ways to get paid by your customers and vendors. Some are simple, like cash, checks, or wire transfers. Others are a little more tricky, depending on the situation. If you have a more complicated transaction—say with an international party—you may need a surefire way to make sure you get the money you’re due. One of the best and most common methods, in this case, is a letter of credit. A letter of credit serves as a way to help ensure your vendor will remain true to their word to pay you, all without having to rely on a personal guarantee or verbal agreement.

A letter of credit is a more complicated financial transaction than those you might be more accustomed to, but it might be the best course of action for your business at some point. In this guide, we’ll break down what a letter of credit is, how a letter of credit helps small business owners, and how you can take advantage of one if the occasion demands it.

Article Table of Contents:

What Is a Letter of Credit?

A letter of credit, or credit letter, is a bank guarantee that a specific payment will be made. As a business owner, you may request a letter of credit from a customer to guarantee payment for products or services you’re providing. In this instance, a letter of credit is the way for an impartial third party—in this case, the bank—to guarantee that your customer can (and will) pay you for the goods or services provided.

The bank serves as an intermediary for payment, issuing a letter of credit that offers protection against a deal going south. A letter of credit helps mitigate the risk of either party not living up to their obligations, which can be essential for a business of any size.

How Does a Letter of Credit Work?

Let’s say your business receives a big order from an overseas company. There are plenty of factors to consider, such as getting the order shipped and making sure it arrives properly and on time. On top of all of that, you also need to get paid—and you’re likely going to want a guarantee that payment will be made, especially since you won’t have much recourse to get your money if your buyer is on the other side of the ocean.

Here’s where a letter of credit is your best ally. A bank, typically located in the buyer’s country, will issue a letter of credit that spells out the buyer’s obligation to the seller. This letter specifies the amount of payment due to the seller, as well as the point in the transaction when the seller will pay for the goods. The party issuing the letter of credit (the bank) will do all of the legwork to make sure your customer has the funds to pay for what they bought and will facilitate the payment process along the way.

A letter of credit functions similarly to an escrow account, where a third party coordinates and holds onto the money needed to complete a transaction on behalf of the other two parties in a deal. This letter certifies that the buyer has good credit (hence the name) and can afford to pay for what they have purchased.

Types of Letters of Credit

How a letter of credit works will also depend on the type of credit letter issued. For instance, with a commercial letter of credit, the bank will make the payment directly to the seller (you). However, with a standby letter of credit, the buyer is still expected to make the payment—if they don’t, then the bank will step in and make good on the payment.

Other types of credit letters include revolving, traveler’s, and confirmed, all of which have their own specific uses. However, for the purpose of small business operations, we’ll be focusing on commercial and standby letters of credit.

The Parties Involved in a Letter of Credit

As you might expect, there are a few groups involved in any deal with a letter of credit. Depending on the kind of deal you’re working on, there may be up to 10 distinct groups involved in making the deal go smoothly. Here’s what each party is and what they do.

The Applicant

The applicant is the buyer in a deal that involves a letter of credit. Since the buyer is applying to a bank for the credit and approval that makes the transaction go through, they’re referred to as an applicant. They have to prove, by way of their application, that they’re a trustworthy partner. The applicant is responsible for sending funds to the issuing bank in order to get the beneficiary (i.e. the seller) the money due.

The Beneficiary

The beneficiary is the seller in a letter of credit transaction. This party typically requests the letter of credit as part of the payment process, and ultimately gets the funds that come along with it from the issuing bank.

The Issuing Bank

The issuing bank reviews and approves the applicant’s credentials, and holds onto the money involved in the letter of credit. The issuing bank is usually located in the applicant’s home country since it works closely with the buyer and handles the international end of the deal. Issuing banks will work with the negotiating bank, which is in the seller’s home country.

The Negotiating Bank

The negotiating bank handles the ins and outs of actually getting the seller paid and works on the beneficiary’s side of the transaction. The beneficiary provides documents and information to the negotiating bank, which will then act as a go-between with the issuing bank (as well as the confirming and advising bank, if they are different from the negotiating bank itself).

The Confirming Bank

A confirming bank offers a guarantee of payment to beneficiaries once the letter of credit requirements are met. This can be the negotiating bank, or may also be a third party depending on the terms of the letter of credit.

The Advising Bank

The advising bank receives the letter of credit involved in a deal and informs the beneficiary when the letter is approved by the applicant’s bank. This too may be the same bank as the negotiating and/or confirming banks.

The Intermediary

An intermediary does what you may assume based on its name. Intermediaries usually connect applicants and beneficiaries to help them strike a deal and can facilitate the creation of a letter of credit to make it all go smoothly.

The Freight Forwarder

Big international purchases don’t often make shipping as easy as slapping postage on a box and sending an order on its merry way. That’s where freight forwarders come in—these companies make international shipping easier and handle the logistics that come with sending products overseas.

The Shipper

Shippers handle the actual transmission of packages and goods being sent from the beneficiary to the applicant.

Legal Counsel

Lawyers can enter the fray with drafting and reviewing a letter of credit’s terms and conditions. It’s usually a good idea to get legal counsel involved in these kinds of deals to make sure that the language of an agreement looks good, is legally acceptable, and that it mitigates risk to either party.

The Benefits of a Letter of Credit

In most cases, a letter of credit is a helpful safeguard for large or complicated business deals. The independent, third-party banking institution does the due diligence behind the scenes and verifies that your customer (or, if you’re on the buying end, your company) has the money and credit required to make the purchase in the first place. Then, the bank holds onto the money and either dispenses it to you directly when the time comes or fulfills the payment if your buyer fails to do so themselves. There’s no fussing over unpaid invoices, partial payments, or issues tracking down an invoice.

All told, a letter of credit helps protect everyone involved in a transaction, too. The buyer gets certain protections as well, such as a guarantee that money won’t change hands until goods hit a certain point in the delivery process. In most cases, this is either when the shipment has arrived at the port of entry or when a freight forwarder ensures that the package is in a certain part of the delivery process.

Another advantage of a letter of credit is the role of a negotiating bank. Negotiating banks work with you domestically to handle portions of the transaction with the issuing bank, which handles all of the buyer-side logistics involved in moving money from the buyer to the seller. These safeguards take out the risk and complicated paperwork involved in the purchase process, which leaves you with fewer headaches that might arise.  

The Downsides of a Letter of Credit

A letter of credit definitely helps the financials of a deal go down smoothly, but they’re not a cure-all for every aspect of the transaction itself. For instance, the letter of credit doesn’t safeguard the passage of goods through international ports, nor does it guarantee that the items purchased will show up in pristine condition. For that, you’ll need a sturdy and legally viable contract of sale.

You may also find that a letter of credit won’t save you from other circumstances, both foreseeable and unforeseeable. If your order gets delayed or doesn’t make it to the buyer, a letter of credit isn’t going to provide you with any recourse. Nor will it give the buyer any protection against getting less than what they accepted, such as counterfeit goods. Even if the goods are authentic, arrive at their destination, and are otherwise in good shape, a letter of credit may not hold up if there’s a delay in getting the appropriate paperwork to one or any of the parties involved in the transaction. Make sure you understand all of the details involved in the transaction; otherwise you may not have the same level of security that you bargained for.

How to Get a Letter of Credit

As a small business owner, you may more often be in the position of requesting your customers to obtain letters of credit, but you may also find yourself in need of obtaining this document yourself. In order to get a letter of credit, the first place you will go is your business’s bank. Since you already have a relationship with this bank and they know your credit history, this is a natural choice.

However, not all banks offer letters of credit. If your bank doesn’t have this service, they should be able to refer you to another bank that does. Once you find an institution to work with, you will simply complete an application and then the bank will decide whether to approve or deny your request based on your credit score, business history, and available funds.

Keep in mind that banks will charge fees for a letter of credit. Typically, this will be a small percentage of the amount you’re guaranteeing—say, 2%—and may also include closing fees, depending on the bank.

Letter of Credit Examples

Whichever bank you work with will have its own letter of credit application process, requirements, and terms. For example, Wells Fargo offers both commercial and standby letters of credit of up to $250,000 for small businesses with $2 million to $5 million in annual sales.[1]

Similarly, Chase offers commercial and standby credit letters for a range of transactions, including a lease or security deposit, payment security for unpaid invoices, and even project performance security.[2] You’ll typically find information about your bank’s letter of credit services in their trade services division.

The Bottom Line

Now that you know the fine print behind a letter of credit, be sure that any transaction that includes a letter of credit checks off all of the boxes that the deal demands. Be sure you can deliver your product in time, as expected, and with all of the guarantees the letter spells out. With the right kind of letter of credit, you can expand your business to far-flung locales and make your small business a little bit bigger.

Article Sources:

  1. WellsFargo.com. “Small Business: Letters of Credit
  2. Chase.com. “Small Business Financing
Brian O'Connor
Contributing Writer at Fundera

Brian O'Connor

Brian O’Connor is a contributing writer for Fundera.

Brian writes about finance, business strategy, and digital marketing. He is the former director of digital strategy at Morgan Stanley, and has worked at Foreign Affairs magazine, Student Loan Hero, and as a partner of a small consulting firm, too. Combined, these experiences allow him to offer a unique perspective on the challenges small business owners face.

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