A letter of credit is a bank's written promise to pay money on your behalf if you meet certain conditions
A letter of credit is a document issued by a bank that guarantees payment to a seller if a buyer holds up their end of a deal. The bank steps in as the middleman, reducing risk for both sides. Instead of the seller trusting the buyer to pay after goods ship, the seller trusts the bank's promise. The buyer gets the goods they ordered, and the bank only pays the seller once the buyer has received what they paid for.
Letters of credit are most common in international trade, where buyer and seller may be in different countries and have no prior relationship. They are also used in construction contracts, real estate transactions, and other situations where large sums of money change hands and both parties want protection.
Key Takeaways
- A letter of credit is issued by a bank and guarantees payment to a seller once specific conditions are met, such as proof that goods have shipped.
- The buyer pays the bank a fee (usually 1 to 3 percent of the letter's value) to issue the letter, and the bank holds the buyer's funds or requires collateral.
- The seller receives payment from the bank only after submitting required documents—typically a bill of lading, invoice, and proof of shipment—that prove the deal terms were fulfilled.
- Letters of credit shift the risk of non-payment from the seller to the bank, making international transactions safer for both parties.
- A letter of credit is not the same as a loan; it is a payment may provide tied to specific conditions, not borrowed money.
How a letter of credit works in a real transaction
Imagine a U.S. clothing company wants to buy fabric from a supplier in India. The U.S. company does not want to send payment before the fabric ships. The Indian supplier does not want to ship before being paid. A letter of credit solves this deadlock.
The U.S. company asks its bank to issue a letter of credit for the amount of the fabric order. The bank agrees, and the company either pays the bank upfront or pledges collateral. The bank then sends the letter to the Indian supplier's bank, confirming that payment is may provide once the supplier ships the fabric and provides proof of shipment.
The Indian supplier ships the fabric and gives the shipping documents to their bank. The bank checks that the documents match the letter of credit's requirements. If everything is in order, the bank pays the supplier. The U.S. company receives the fabric and reimburses the bank (if it has not already). Both parties got what they wanted, and the bank took a small fee for managing the risk.
The documents the seller must provide to get paid
The seller does not automatically receive payment just because a letter of credit exists. The bank will only pay once the seller submits documents proving that the agreed-upon conditions have been met. These documents vary depending on the deal, but common ones include:
- A bill of lading — proof from the shipping company that goods have been loaded onto a vessel and are on their way.
- A commercial invoice — the seller's bill showing what was sold, the price, and the buyer's details.
- A packing list — a detailed breakdown of what is in each shipment.
- A certificate of origin — proof of where the goods were made, often required for international shipments.
- An inspection certificate — confirmation from a third party that the goods meet the quality or quantity specified in the order.
The bank examines these documents carefully. If they match the terms of the letter of credit exactly, the bank pays the seller. If there are discrepancies—for example, the invoice shows a different quantity than the letter of credit allows—the bank will not pay until the issue is resolved.
What the buyer pays for a letter of credit
The buyer does not receive a letter of credit for free. The issuing bank charges a fee, typically between 1 and 3 percent of the letter's total value, though this varies by bank, the buyer's creditworthiness, and the complexity of the transaction. A letter of credit for a $100,000 shipment might cost $1,000 to $3,000.
The buyer also needs to have funds available or collateral to back the letter. Some banks require the buyer to deposit the full amount in an account the bank controls. Others allow the buyer to pledge assets like inventory or equipment as security. If the buyer cannot pay the bank after the seller has been paid, the bank can seize the collateral.
Additional costs may explore if the letter needs to be amended (changed), if it is confirmed by a second bank, or if the bank has to handle discrepancies in the seller's documents.
Different types of letters of credit and when they are used
Not all letters of credit work the same way. The type used depends on the transaction and the level of risk both parties are willing to accept.
A revocable letter of credit can be cancelled or changed by the buyer without the seller's permission. This is rare in modern trade because it offers the seller almost no protection. A irrevocable letter of credit cannot be changed or cancelled without agreement from both the buyer and the seller, making it much safer for the seller.
A confirmed letter of credit means a second bank (usually the seller's bank) adds its own may provide on top of the issuing bank's promise. This gives the seller extra security, especially in international deals where the issuing bank is in a country with political or economic risk.
A standby letter of credit works differently. Instead of guaranteeing payment for goods, it guarantees that the buyer will perform some other obligation—such as completing a construction project or repaying a loan. The seller only calls on the standby letter if the buyer fails to do what they promised.
Why banks use letters of credit to manage risk
From the bank's perspective, a letter of credit is a controlled way to take on risk. The bank does not lend money; it guarantees payment only if specific, documented conditions are met. The bank can review the seller's documents before paying, reducing the chance of fraud or breach of contract.
The bank also collects a fee and holds the buyer's funds or collateral, which offsets the risk. If the buyer cannot reimburse the bank after payment is made to the seller, the bank has already secured the funds or can seize the pledged assets.
For international transactions, letters of credit also help banks manage currency risk and political risk. A bank in one country can issue a letter of credit that is confirmed by a bank in another country, spreading the risk across institutions in different financial systems.
How a letter of credit differs from other payment methods
A letter of credit is not a loan. With a loan, the bank lends money to the buyer, who then owes the bank that money plus interest. With a letter of credit, the bank guarantees payment to the seller on the buyer's behalf, but the buyer must reimburse the bank once the seller has fulfilled the contract.
A letter of credit is also different from a straightforward bank transfer or wire. With a wire, money moves directly from the buyer's account to the seller's account with no conditions attached. Once sent, it cannot be reversed. A letter of credit adds a layer of verification: the bank checks documents before releasing funds, and the seller must prove they have done what they promised.
A letter of credit is also not a may provide of the quality of the goods. The bank only verifies that documents match the letter's terms. If the seller ships inferior goods but includes all the correct paperwork, the bank will still pay. The buyer would then have to pursue a separate claim against the seller for breach of contract.
Frequently Asked Questions
What happens if the seller's documents do not match the letter of credit?
The bank will not pay until the discrepancy is resolved. The seller can either submit corrected documents, or the buyer can authorize the bank to pay despite the mismatch. If neither happens, the seller does not get paid, and the letter of credit expires unused. This is why sellers review the letter of credit carefully before shipping goods.
Can the buyer cancel a letter of credit after it is issued?
Only if the letter is revocable, which is rare. Most letters of credit are irrevocable, meaning the buyer cannot cancel without the seller's written consent. Even then, the buyer still owes the bank the fee and must maintain collateral or funds until the letter expires or is used.
Who pays the bank's fee for the letter of credit?
The buyer pays the fee to the issuing bank. Sometimes the buyer and seller negotiate who bears this cost as part of the overall price, but the buyer is responsible for arranging and paying for the letter itself.
Is a letter of credit the same as a credit line?
No. A credit line is borrowed money the buyer can draw on and repay over time. A letter of credit is a one-time may provide tied to a specific transaction. The buyer does not borrow money; the bank guarantees payment to the seller if conditions are met.
What if the buyer runs out of money to reimburse the bank after the seller is paid?
The bank can seize the collateral the buyer pledged when the letter was issued. If no collateral was pledged and the buyer has no funds, the bank may pursue legal action to recover the amount it paid to the seller on the buyer's behalf.