What is Letter of Credit? How does it work?

As the world has progressed, so has the number of ways which can help you to get credit easily. One of the easiest ways to get credit is a personal loan, but there are many other forms of credit that could be better as well, such as the Letter of Credit.

So, how does the letter of Credit work? Is it better than going for a personal loan? In this blog, we will help you find out whether the Letter of Credit is better, what are its specific benefits and more.

If you are experiencing troubles with your trade or business, then, you can always approach Airtel Finance for help. Airtel Personal Loans offer credit at very low rates of interest, the process is 100% digital, and you can get instant credit approval. Get yours today from the Airtel Thanks app!

What is a Letter of Credit?

A Letter of Credit (LC) is a written commitment from a bank, at the request of a buyer (importer), guaranteeing that the seller (exporter) will receive payment for goods or services provided, as long as the seller complies with the terms and conditions outlined in the LC. Essentially, it mitigates the risk associated with international transactions by ensuring that the seller gets paid once they fulfill their contractual obligations.

Who are the key parties involved in the Letter of Credit?

Here are all the important parties involved in the Letter of Credit:

• Applicant (Buyer/Importer): The party requesting the Letter of Credit from their bank.
• Beneficiary (Seller/Exporter): The party in whose favour the Letter of Credit is issued.
• Issuing Bank: The bank that issues the Letter of Credit at the request of the applicant.
• Advising Bank: The bank, usually located in the exporter’s country, that advises the beneficiary of the Letter of Credit.
• Confirming Bank: Sometimes, an additional bank (often the advising bank) provides a confirmation, adding its own guarantee to the Letter of Credit.
• Negotiating Bank: The bank that examines the documents presented by the beneficiary and negotiates the payment.

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How does the Letter of Credit work?

Here is how the Letter of Credit works between all the parties:

• The buyer and seller agree on the terms of the sale, including the use of a Letter of Credit as the payment method.
• The buyer requests their bank (the issuing bank) to issue a Letter of Credit in favour of the seller.
• The issuing bank issues the LC and sends it to the advising bank in the seller’s country.
• The advising bank verifies the authenticity of the LC and advises the seller that the LC has been issued.
• The seller ships the goods as per the contract and prepares the necessary documents (such as the bill of lading, commercial invoice, packing list, etc.).
• The seller presents the required documents to the advising bank, which then forwards them to the issuing bank.
• The issuing bank verifies the documents to ensure they comply with the terms of the LC.
• Once the documents are verified, the issuing bank makes the payment to the advising or negotiating bank, which then credits the seller’s account.
• The issuing bank reimburses itself from the buyer, either by debiting the buyer’s account or through pre-arranged credit terms.

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What are the different types of letters of credit?

Here are some of the varying kinds of letters of credit:

Revocable and Irrevocable Letter of Credit

A revocable LC can be amended or canceled by the issuing bank without prior notice to the beneficiary, while an irrevocable LC cannot be altered or canceled without the agreement of all parties involved.

Confirmed and Unconfirmed Letter of Credit

A confirmed LC has an additional guarantee from a second bank (the confirming bank), whereas an unconfirmed LC does not.

Sight and Time Letter of Credit

A sight LC requires payment to be made immediately upon presentation of compliant documents. A time (or usance) LC allows for payment at a future date.

Transferable Letter of Credit

Allows the beneficiary to transfer all or part of the credit to another party, typically a supplier.

Standby Letter of Credit

Acts as a secondary payment method, often used as a guarantee that the buyer will fulfill their obligations under a contract.

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Benefits of Using a Letter of Credit

Here are some of the benefits of using a Letter of Credit:

• Provides a high level of security for both buyers and sellers, ensuring payment and delivery.
• Reduces the risk of non-payment for sellers and non-delivery for buyers.
• Helps bridge the trust gap in cross-border transactions where parties may not know each other well.
• Offers various types of LCs to cater to different business needs and scenarios.

In essence, a Letter of Credit is a vital tool in international trade. It is especially used by exporters and importers to effectively manage their international transactions and mitigate associated risks. Hopefully, this blog helped you understand how the Letter of Credit works. But if you simply want to get credit, just get a loan from Airtel Personal loans and repay the loan with relaxed EMIs!