Letter of Credit | Definition & Different Types

Learn what is a letter of credit and of the different types including site, stand by, acceptance, transferable, revolving and more.



What is a Letter of Credit

A letter of credit (L/C) is written by a bank to a seller guaranteeing that it will pay the debt owed at specified time if the buyer fails to pay as agreed. Letters of credit are mostly use in international transactions. This is because of the nature of international trade. The bank will also protect the interest of the buyer by ensuring that payments are not released to the seller until it has received confirmation that the goods bought have been shipped. There are many different types as follows:

Different Types of Bank Letters of Credit:

The different types of letters of credit include:

Sight

When this line of credit is issued, the seller will receive payment immediately after the required document are submitted to the bank. All the conditions of the line of credit must be met before the seller receives payment. The banks are usually given a reasonable time to before making the payments for checking purposes. In most cases, the time does not exceed 5 days.

Acceptance

With this type of credit, the documents will be submitted but payment will not be made until a date specified in the line of credit. The seller will be allowed to requests a discount from the institution that accepted the bill of exchange or form another bank of choice. This allows the seller to draw the money in the bill minus the discount after the documents have been submitted.

Transferable

These L/C are well adapted to businesses that are involved in international trade. The transferable line of credit allows an intermediary to transfer a L/C to a supplier to make it possible for the intermediary to reduce the funds used to process business transactions.

Revolving

This L/C is usually used when the buyer requires for partial deliveries of the goods ordered at specified intervals. The payments are made in installments. Each consecutive payment made covers the value of the goods delivered to the buyer. The bank is liable for the value of all the partial deliveries. The second payment cannot be effected before the first one has been made.

Standby

The letters of credit are similar to guarantees. If the guaranteed payment is not made, the seller can invoke a bank’s obligation to pay. This is done by submitting the letter of credit together with other relevant documents and a declaration that states that the customer failed to pay as agreed.

The red clause

When this L/C is used, the seller can request for an advance payment from the bank that is supposed to issue payment. This advance is usually meant to facilitate the purchase or manufacture the goods that are supposed to be delivered to the buyer. The advance is paid against a receipt and an undertaking(written) by the seller to provide the transportation documents.

The green clause

Here, the advance is paid not only against a receipt and a written undertaking by the seller to provide transportation documents, an additional document that proves that the goods to be shipped have been put in a warehouse is also required.