# Understanding Letters of Credit: Definition, Types, and Usage

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## What Is a Letter of Credit?

A letter of credit is a crucial financial instrument in international trade, providing a guarantee from a bank that a buyer’s payment to a seller will occur on time and for the specified amount. When buyers face challenges in meeting their financial commitments, the [bank](https://www.investopedia.com/the-best-online-banks-11722209) steps in to cover unpaid amounts, ensuring seamless trade transactions.

This arrangement is vital in overcoming challenges inherent in international dealings, such as differing national laws and the geographical distance between trading parties. As a result, letters of credit are indispensable in protecting both buyers and sellers from potential risks during trade.

### Key Takeaways

*   A letter of credit is a financial instrument issued by a [bank](https://www.investopedia.com/the-best-online-banks-11722209) that guarantees a buyer’s payment to a seller, enhancing trust and security in international trade.
*   Common types of letters of credit include commercial, revolving, confirmed, and standby, each serving different business needs and transaction structures.
*   Banks charge fees for issuing letters of credit, often a percentage of the credit amount, with costs varying based on the type and risk involved.
*   Letters of credit require buyers to provide collateral and can be complex to set up, yet they play a vital role in facilitating global commerce by mitigating payment risk.
*   In unstable economic climates, banks like Citibank use letters of credit to minimize country and commercial credit risks, especially in emerging markets.

## Understanding Letters of Credit

Buyers that make major purchases can use a letter of credit to assure the seller that the payment will be made. A bank issues a letter of credit to guarantee the payment to the seller, essentially assuming the responsibility of ensuring the seller is paid. A buyer must prove to the bank that they have enough [assets](https://www.investopedia.com/terms/a/asset.asp) or a sufficient [line of credit](https://www.investopedia.com/terms/l/lineofcredit.asp) to pay before the bank will guarantee the payment to the seller.

> **Important**
>
> Banks usually need securities or cash as collateral to issue a letter of credit.

As a [negotiable instrument](https://www.investopedia.com/terms/n/negotiable-instrument.asp), a letter of credit allows the issuing bank to pay either the beneficiary or a bank they nominate. If a [letter of credit is transferable](https://www.investopedia.com/terms/t/transferable-letter-of-credit.asp), the [beneficiary may assign another entity](https://www.investopedia.com/terms/a/assignment_of_proceeds.asp), such as a corporate parent or a third party, the right to draw.

The ICC’s Uniform Customs and Practice for Documentary Credits regulates letters of credit in international transactions.  

### How Much Do Letters of Credit Cost?

Banks often charge fees for letters of credit, usually a percentage of the credit amount. The cost of a letter of credit will vary by bank and the size of the letter of credit. For example, the bank may charge 0.75% of the amount that it's guaranteeing.

Fees also vary by letter type. In import-export, for example, an unconfirmed letter of credit generally costs less. A confirmed letter of credit usually has higher fees based on the issuing bank's credit strength, and it generally takes longer to process the transaction.

## Different Types of Letters of Credit

The types of letters of credit include:

*   Commercial letter of credit
*   Standby letter of credit
*   Revolving letter of credit
*   Traveler’s letter of credit
*   Confirmed letter of credit  
    

International trade will also sometimes use an unsecured letter of credit, also called a [red clause](https://www.investopedia.com/terms/r/red-clause-letter-of-credit.asp) letter of credit.

### Commercial Letter of Credit

This is a direct payment method in which the issuing bank makes the payment to the beneficiary. In contrast, a [standby letter of credit](https://www.investopedia.com/terms/s/standbyletterofcredit.asp) is a secondary payment method in which the bank pays the beneficiary only when the account holder cannot.

### Standby Letter of Credit

A standby letter of credit provides payment if something does not occur, which is the opposite of how other types of letters of credit are structured. So, instead of facilitating a transaction with funding, a standby letter of credit is like an insurance contract. It protects and compensates one party (the beneficiary) if the other party named in the agreement fails to perform the stated duty or meet certain service level agreements outlined in the letter of credit.

### Revolving Letter of Credit

A revolving letter of credit allows a customer to make any number of draws up to a certain limit during a specific period. It can be useful if there are frequent merchandise shipments, for example, and you don't want to redraft or edit letters of credit each time.

### Traveler’s Letter of Credit

For those going abroad, this letter of credit will guarantee that issuing banks will honor drafts made at certain foreign banks.

### Confirmed Letter of Credit

A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank [default](https://www.investopedia.com/terms/d/default2.asp). The issuing bank in international transactions typically requests this arrangement.

## Real-World Example of a Letter of Credit in Action

Citibank offers letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East, who may have difficulty obtaining international credit on their own. Citibank’s letters of credit reduce country and commercial credit risks for exporters.

Letters of credit guarantee payment by the confirming Citibank branch. This benefit is crucial for clients in unstable economies.

## How to Apply for a Letter of Credit

Professionals should prepare letters of credit to avoid costly mistakes and payment delays. Due to industry variations and the variety of letters of credit, each may be approached differently.  

Here's an import-export example.

1.  The importer's bank's credit must satisfy the exporter and their bank. The exporter and importer complete a sales agreement.
2.  Using the sales agreement's terms and conditions, the importer's bank drafts the letter of credit; this letter is sent to the exporter's bank. The exporter's bank reviews the letter of credit and sends it to the exporter after approval.
3.  The exporter ships the goods as the letter of credit describes. Any required documentation is submitted to the exporter's bank.
4.  The exporter's bank reviews documentation to ensure letter of credit terms and conditions were met. If approved, the exporter's bank submits documents to the importer's bank.
5.  The importer's bank sends payment to the exporter's bank. The importer can now claim the goods sent.

## Pros and Cons of Letters of Credit

Obtaining letters of credit may be necessary in certain situations. However, like anything else related to banking, trade, and business, there are some pros and cons to acknowledge.  

### Pros and Cons of Letters of Credit

Pros

*   Can create security and build mutual trust for buyers and sellers  
    
*   Makes it easier to define when and how to complete transactions
    
*   Can be personalized to the circumstances of each transaction
    
*   Can make the transfer of funds more efficient and streamlined
    

Cons

*   Buyers typically bear the costs
    
*   May not cover every detail of the transaction, leaving room for error
    
*   May be tedious or time-consuming for all parties involved
    
*   Terms may not account for changes in the political or economic landscape
    

## Frequently Asked Questions (FAQs)

## How Does a Letter of Credit Work?

In international trade, letters of credit are used to signify that a payment will be made to the seller on time and in full, as guaranteed by a bank or financial institution. After sending a letter of credit, the bank will charge a fee, typically a percentage of the letter of credit, in addition to requiring [collateral](https://www.investopedia.com/terms/c/collateral.asp) from the buyer. There are various types of letters of credit, including revolving, commercial, and confirmed.

## What Is an Example of a Letter of Credit?

Consider an exporter in an unstable economic climate, where credit risk is high. To reduce risk, a buyer of the exporter's goods arranges a letter of credit through their bank. The bank issues the letter of credit, which guarantees payment to the exporter once the terms are met. This setup gives the exporter confidence that they'll be paid, even if the buyer defaults, because the bank backs the payment. It also helps the buyer secure goods in situations where the seller might otherwise require upfront payment.

## When Does Payment Occur With a Letter of Credit?

A letter of credit is similar to an escrow account, in that payment to the beneficiary only occurs when the other party performs a specific act or meets other performance criteria spelled out in the letter of credit agreement, such as delivering goods.

## What Is the Difference Between a Commercial Letter of Credit and a Revolving Letter of Credit?

One of the most common forms of letters of credit, commercial letters of credit have the bank make the payment directly to the beneficiary or seller. Revolving letters of credit, by contrast, can be used for multiple payments within a specific time frame. Typically, these are used for businesses that have an ongoing relationship, with the time limit of the arrangement usually spanning one year.

## The Bottom Line

Letters of credit can play an important role in trade transactions. There are different types of letters of credit that may be used, depending on the circumstances. If you need a letter of credit for a business transaction, your current bank may be the best place to begin your search. However, you may need to expand the net to include larger banks if you maintain accounts at a smaller financial institution.

> **Article Sources**
>
> 1.  International Trade Administration. "[What Is a Letter of Credit?](https://www.trade.gov/letter-credit)"
>     
> 2.  International Chamber of Commerce. “[Global Insights](https://iccwbo.org/global-issues-trends/banking-finance/global-rules/).”
>     
> 3.  Export-Import Bank of the United States. "[To Confirm or Not to Confirm (Letters of Credit)](https://grow.exim.gov/blog/to-confirm-or-not-to-confirm)."
>     
> 4.  Cornell Law School. "[12 CFR § 208.24 - Letters of credit and acceptances.](https://www.law.cornell.edu/cfr/text/12/208.24)"
>     
> 5.  Columbia Bank. "[Letters of Credit.](https://www.columbiabank.com/business-banking/international-banking/letters-of-credit)"
>     
> 6.  USAID. "[Letters of Credit and Trade Finance](https://pdf.usaid.gov/pdf_docs/PNADJ883.pdf)," p.106.
>     
> 7.  FDIC. "[Off-Balance Sheet Activities](https://www.fdic.gov/regulations/safety/manual/section3-8.pdf)," p.2
>     
> 8.  Citi. “[International Trade](https://www.citibank.com/icg/sa/latam/bahamas/trade/).”
>     
> 9.  Citi. “[Products and Services](https://www.citibank.com/icg/sa/emea/romania/english/products-services/trade-services/trade-services.html).”
>     
> 10.  International Trade Administration. "[Letter of Credit.](https://www.trade.gov/letter-credit)"
>      
> 11.  International Trade Administration. "[Trade Finance Guide](https://legacy.trade.gov/TradeFinanceGuide_All.pdf)," Page 7.