A letter of credit is a document, typically issued by a financial institution, guaranteeing that a buyer will make payment -- on time and for the correct amount -- to a seller of goods or services. In essence, the letter assures the seller he'll receive payment even if the buyer fails to pay. Likewise, the document ensures that the supplier meets all the agreed-upon specifications for the goods as stated in the letter of credit. Letters of credit are an integral part of international transactions. By being conversant with how these financial instruments work, you can earn interest on a letter of credit as a seller of goods or services.
Letter of Credit Types
Letters of credit are typically negotiable financial instruments designed to suit all parties to the transaction. A commercial letter of credit is the primary payment mechanism: The issuing bank will pay the seller regardless of whether the buyer has the means to pay. A standby letter of credit is a secondary payment mechanism: The issuing bank will only pay the beneficiary when the buyer is unable to. A revolving letter of credit allows the seller to make any number of withdrawals within a certain period subject to a certain limit. A confirmed letter of credit has another bank -- typically the seller's bank -- endorsing it that will ensure payment if the holder and the issuing bank default.
The typical process for a letter of credit is for the buyer and seller to agree to conduct business and agree that the seller needs a letter of credit from the buyer to guarantee payment. If the buyer's risk is approved by the bank, it will issue the letter of credit to the seller's bank. Upon notification by his bank, the seller will ship the goods and present necessary documents to his bank for payment processing. The bank will verify the documentation for compliance with the terms, conditions and stipulations of the letter of credit. Once this is verified, the seller's bank will debit the account of the buyer's bank.
Collateral, Fees and Rates
Although the issuing bank will promise to pay on behalf of the buyer, the buyer has to show capacity to provide money behind the letter of credit. The bank may require the buyer to deposit enough money to cover the letter of credit or to use a line of credit offered by the issuing bank. Fees and commissions are met by the buyer. An interest rate is usually established based on the amount involved and how long the buyer has to wait before receiving the goods. All three parties have to confirm the terms are agreeable.
The letter of credit will have a clear time frame that defines when the goods are to be delivered or payment made. If goods are delivered and payment is not made by the specified deadline, the seller will start to earn interest as agreed upon in the letter of credit. Likewise, if the the seller does not meet the schedule time frame and delivery is delayed, the purchaser will receive discounts, or interest returned to him, depending on the contract language.
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