Establishing trust can be a challenge for new business partners or those that aren’t working in the same physical location. Especially in these scenarios, it is essential for both the buyer and the seller to know that the agreement made will be kept, both when products are delivered and when money is released.
A Letter of Credit (LC) promises this safety by making a bank responsible for facilitating the transaction. It sets out a framework for payment that works in the favour of the buyer and the seller, a financial product used in international and domestic commerce.
What is a Letter of Credit?
An LC is a written promise from a buyer’s bank to that seller guaranteeing payment on the condition that the terms of the LC are met. The seller can then trust that their payment will be released once they present the proper documents, rather than depending solely on the buyer.
An LC sets forth all the payment terms and conditions. It specifies which documents the seller needs to submit and who is responsible for what. By doing this, it reduces the payment risk of a transaction and facilitates more secure trade.
How Does a Letter of Credit Work?
An LC follows a step-by-step process involving the buyer, the seller and their respective banks. Payment is released only after the required documents are verified according to the agreed terms.
The process generally works as follows:
Step 1: The buyer and seller agree on the terms of the deal.
Step 2: The buyer requests their bank to issue an LC.
Step 3: The issuing bank sends the LC to the seller’s bank.
Step 4: The seller ships the goods or delivers the agreed services.
Step 5: The seller submits the required documents to the bank.
Step 6: Once the documents are verified, the payment is released according to the terms mentioned in the LC.
When is a Letter of Credit Used?
An LC is commonly used when businesses want a formal banking arrangement to facilitate payments, particularly in transactions where the buyer and seller don’t have an established business relationship or where large transaction values are involved.
It is commonly used in situations such as:
- Import and export transactions
- Cross-border trade
- High-value commercial purchases
- Transactions with new suppliers or customers
- Deals involving extended payment terms
By setting clear payment conditions before a transaction begins, an LC helps businesses manage commercial transactions in a more organised and predictable manner.
Which Types of Letter of Credit are Commonly Used?
Letters of credit are of different types, and they are designed for different business transactions and payment requirements. The form of contract used depends on the agreement between buyer and seller, the degree of payment assurance required, and the nature of the trade.
Some of the most commonly used types of LC include the following:
| Type | Purpose |
| Revocable LC | Can be amended or cancelled by the issuing bank before payment |
| Irrevocable LC | Cannot be modified without the consent of all parties involved |
| Confirmed LC | Includes an additional payment commitment from another bank |
| Standby LC | Acts as a backup payment arrangement if the buyer fails to meet the agreed obligation |
| Transferable LC | Allows the beneficiary to transfer the credit to another party |
| Revolving LC | Suitable for repeated transactions between the same buyer and seller without issuing a new credit each time |
The appropriate type depends on the transaction, the trading relationship and the level of assurance required by both parties.
Why Do Businesses Use a Letter of Credit?
Businesses use an LC to establish a structured payment process for commercial transactions, particularly when dealing with new trading partners or high-value orders. Since payment is linked to agreed-upon terms and supporting documents, it creates greater clarity throughout the transaction.
Some of the key advantages include:
- Clearly defined payment conditions before the transaction begins
- Better documentation for trade and banking purposes
- Fewer payment-related disputes due to pre-agreed terms
- Greater confidence when trading with new buyers or suppliers
- A recognised payment mechanism for both domestic and international trade
For businesses involved in trade finance, an LC can also support smoother commercial transactions by ensuring every individual follows the agreed process.
How is a Letter of Credit Different from a Bank Guarantee?
An LC facilitates payment during a commercial transaction, while a bank guarantee provides financial protection if one party fails to fulfil its contractual obligation. Although both are issued by banks, they serve different business purposes.
| Letter of Credit | Bank Guarantee |
| Supports the payment process in a transaction | Covers financial loss if contractual obligations aren’t met |
| Commonly used in trade transactions | Often used in contracts, tenders and infrastructure projects |
| Payment is released after the required conditions are fulfilled | Payment is made only if the guaranteed obligation isn’t honoured |
| Primarily benefits buyers and sellers involved in trade | Primarily protects the beneficiary against financial default |
Choosing between the two depends on the nature of the transaction and the level of financial assurance required.
Read More: Loan Against Property (LAP): Meaning, Eligibility, Interest Rates & Benefits
Conclusion
An LC continues to be an important payment instrument for businesses involved in domestic and international trade. Knowing how it works, when it’s used, and the different types of LC can help businesses choose the right payment arrangement for different commercial transactions.
At Lendingkart, we understand that growing businesses need both efficient payment mechanisms and timely access to working capital. While an LC helps facilitate trade transactions, businesses may also require additional funding to manage inventory, fulfil large orders or support expansion. That’s why we work towards making business financing simpler for eligible MSMEs through a digital-first application process, helping businesses move forward with greater confidence.
FAQs
1. What is a Letter of Credit?
An LC is a bank-issued document that confirms payment to a seller after the agreed terms and supporting documents have been fulfilled.
2. What are the different types of Letter of Credit?
Some common types of LC include revocable, irrevocable, confirmed, standby, transferable and revolving letters of credit.
3. Is a Letter of Credit used only for international trade?
No. Although commonly used in international trade, an LC can also be used for domestic commercial transactions.
4. Who issues a Letter of Credit?
An LC is issued by the buyer’s bank after receiving a request and verifying the applicable requirements.
5. Who pays the charges for a Letter of Credit?
The charges are generally paid by the buyer unless both parties agree on a different arrangement in their commercial contract.
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