Before you dive in:
- Learn cash flow and avoid needing a Letter of Credit
- Apply for a letter of credit even though you don’t need one
- Even when you think you know, learn it again
More about a business letter of credit:
- Used for B2B (Business to Business) transactions
- Gives assurance to a supplier that they will get paid in full and on time
- Letters of credit are used often in international trade transactions
- They can be used in numerous circumstances for small businesses, such as construction projects or purchasing a large amount of inventory.
Types of Letters of Credit
Letters of credit can be used by a buyer of a product and the seller of a product and each one, though the same in principle and intent, are worded and set up differently.
Sellers Letter of Credit
If you’re buying a product or service from a business a letter of credit would assure payment if the buyer fails to pay the seller. The financial institution would have to pay the seller as long as the requirements of the letter were met.
Irrevocable Letter of Credit
An irrevocable letter of credit refers to the official correspondence from a bank that guarantees the payment to the applicant. The letter of credit can not be modified in any way, shape or form except if all parties involved (the buyer, seller, and issuing bank) agree.
Standby Letter of Credit
A standby letter of credit, or SBLC, is a guarantee of payment to a seller from an issuing bank but only if the buyer defaults on the agreement. The agreement must be followed exactly or else the bank will not be obligated to make the payment.
How Does a Letter of Credit Work?
A letter of credit is most often issued by a large bank or international bank, and there is a process to follow to purchase one. Typically, the buyer will purchase a letter of credit in their home country. The parties involved in a letter of credit include the buyer, seller, and the bank.
Before a bank will issue a letter of credit:
- it will conduct a background check on the buying company, check the credit, and possibly require a deposit.
- There are also documentation requirements, including invoices, bills of exchange, licenses and other government documentation, and shipping and transportation documents.
Once approved, the letter is drafted and will outline the terms and conditions of the payment. It includes not only the payment schedule, but also when the goods or service are expected.
In the event the payment terms are not met, the bank will issue the payment but only after all the requirements outlined in the letter have been met.
Costs of a Letter of Credit
As with all types of business funding, there are costs associated with obtaining a letter of credit.
- Most banks require a 1% deposit from the buyer.
- The letter usually costs around 0.75% of the total purchase amount, but can go as high as 1.5% depending on the bank.
There will also be fees involved, including courier fees, transfer, wiring, and bank fees. While the buyer may be the one picking up the cost of the letter of credit, the seller may be responsible for some of the fees too.
The Pros and Cons of Letters of Credit
If you’re a small business owner, then you may need to weigh the pros and cons of this type of transaction at some point, especially if you have a lack of other financing options or credit.