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- A letter of credit and a line of credit are both forms of funding or loans that sound similar but are very different in their execution.
- A letter of credit legally obligates a bank to pay a supplier and keep the supply going if the business owner can't pay the supplier at the time required.
- A line of credit is a loan where the business owner has funds always available to spend, at his discretion, on all his business needs that is automatically renewed (without any paperwork) when the funds are returned and interest paid.
What is a Letter of Credit?
A letter of credit is an agreement given by a business owner to a supplier promising that in case they can't pay a bank/lender or another 3rd party will.
If the conditions outlined in the agreement are met, and the buyer does not make good on the payment, then the 3rd party is legally obligated to make the payment.
The letter of credit is designed to reduce the risk to the seller. There are various forms of letters of credit, some of which require more paperwork and documentation than others. For example, an irrevocable letter of credit requires all parties (including both banks) to agree to any changes in the documentation at all times.
Here are additional features of letters of credit:
- Letters of credit are commonly used in international trade
- Businesses must meet requirements to get the funds outlined in a letter of credit.
What is a Line of Credit?
A business line of credit is a loan issued by a bank or another financial institution. Like a credit card, it provides you with a fixed sum of money that you can draw on when you require it and then pay back straight away or over a specific period.
Here are key features of a line of credit:
- You will be charged interest (The cost of the loan) once you borrow money
- The bank needs to approve all borrowers, where approval is based on the borrower’s connection with the bank and credit rating
- The interest rate is typically variable, so it is hard to know what you will eventually need to pay back
There are two main options for a line of credit: secured and unsecured business line of credit. Secured requires collateral, while the unsecured option does not. To discover more about the difference between a secured and an unsecured line of credit read out article titled: Unsecured business line of credit: what it is and how it works. For an updated list of the most recommended lenders, visit our article about the best unsecured business line of credit companies.
Letter of Credit vs Line of Credit: Usage Comparison
Here are key differences better a letter of credit vs line of credit:
Usage - a letter of credit is used when a seller wants to ensure payment from a buyer. Both parties must meet certain conditions (typically related to the delivery of goods). A line of credit is used when a business needs funding to support its expenses, like taking an equipment line of credit for new machinery.
Flexibility - letters of credit are not as flexible because they require major documentation and a lengthy application process. A line of credit is designed to be flexible so the borrower can access the funds at any time, within the credit limit.
Fees and Rates - a customer does not pay interest for a letter of credit. Rather the fees of a letter of credit are the bank commissions. These fees are generally a percentage of the transaction. The buyer and seller may have to pay additional banking, wiring transfer, and courier fees. With a line of credit, you pay interest on the amount you choose to withdraw, plus any other account fees.
Parties involved - a letter of credit involves four parties, including the buyer, the seller, and the third-party financial institutions of each. A line of credit only involves the borrower and the lending institution.
Geography - a letter of credit originates with the buyer’s home country and is usually used as a part of international trades. A line of credit is often a local or online option.
Fees and Rates
Letter of Credit
Used once between a buyer and seller to guarantee payment.
Requires large amounts of paperwork and documentation.
Letter of credit rates are a flat percentage based on the amount of the transaction, plus banking fees.
Involves a buyer, seller, and bank.
Can be used globally for international trades, or domestically.
Line of Credit
Funds can be used for any business-related expenses.
Can be accessed at any point whenever funding is needed. As long as it is within borrowing limits.
You will need to pay interest rate and account opening fees.
Involves a borrower and a lending institution.
Is only used domestically.
When to Use a Letter of Credit
Here are core uses of a letter of credit:
- Guarantee payment - a letter of credit is used when a seller needs to guarantee payment from a buyer. Or your business may be the seller, where you sell goods or services to a buyer and guarantee payment.
- Reduce risk - you can use the letter to move a sale forward and reduce some of the risks to the seller.
- Assurance of payment - as a business owner, you may be the buyer who does not have established credit, so the seller wants the reassurance that they will get paid.
Here are some requirements of a letter of credit:
- Demand paperwork - letter of credit financing require a large amount of paperwork, much of which is centered around the buyer's creditworthiness and shipping documentation.
- An irrevocable letter of credit - If an irrevocable letter of credit is requested, the approval process might take longer. Letter of credit costs are generally high.
When to Use a Line of Credit
Here are the core uses of a line of credit:
Shortfall in revenue - a small business owner may choose to use a line of credit whenever there are shortfalls in revenue, and there’s a need to pay for business expenses.
Cover varied expenses - Lines of credit cover a wide range of expenses, including payroll, purchasing inventory, investing in real estate, or obtaining materials for production.
Flexible - a line of credit may be flexible and accessed at almost any time.
Fast funding - once approved, a business owner is likely to access funds within minutes. However, there are costs involved for the borrower.
Includes fees - a line of credit will be subject to an interest rate, a set repayment schedule, and various fees.
Reduced by sum borrowed - the line of credit will be reduced by the amount borrowed and will not be restored until you make the payment.
We have seen how a letter of credit vs. line of credit have two distinct purposes. A letter of credit is best when you want guaranteed payment. A line of credit is better for situations where you need funding for business-related expenses fast.
Fundbox is a top option for an unsecured business line of credit. It offers flexible financing solutions that small business owners find useful, and there are flexible repayment terms plus competitive interest rates. If your business quickly needs access to funds, then Fundbox is a suitable option.