If you make international transactions, you may have various international payment methods to choose from so that you would be confused and unsure which is the right one for your business. You must hear about the letter of credit among these payment methods and may be confused about what the L/C is.
This article introduces basic information about the letter of credit, including import L/C (import letter of credit) and export L/C (export letter of credit), letter of credit of process and some types of L/C.
What is the Letter of Credit?
A letter of credit is a common payment method used widely in global transactions. When you make business with customers from other countries, you may be worried about payments and goods delivery. As buyers, you worry that the seller won’t deliver goods according to the contract after receiving payments; as sellers, you worry that the buyer won’t send payments after getting goods.
In this case, two banks are needed to be guarantors for both parties to help transactions completed. According to the demands of applicators (usually importers), the bank issues documents in accordance with terms of credit and sends payments at sight or forward. The used documents are the so-called letter of credit. Generally, it is a kind of conditional commitment to pay.
Export L/C &Import L/C
What is Import L/C?
The import L/C refers to the documents issued by issuing banks in accordance with applicants (importers) and sent to the beneficiary (exporters). It helps provide credit proof so that importers can take delivery of goods with it.
What is Export L/C?
The export letter of credit is usually regarded as the import letter of credit that the remitting bank receives from the importer and the issuing bank. It provides a series of services for exporters, including credit notice, receiving and sending documents for claiming.
The export L/C helps exporters be able to ship goods before receiving payments and ensures the payments they receive are consistent with the terms and conditions of the L/C.
Differences between Import and Export L/C
The import letter of credit is issued by the issuing bank of the importer, which is used to claim that the exporter or the seller is the beneficiary. Once the import L/C has been confirmed by the exporters’ bank, it would become the export L/C automatically.
For importers, the L/C ensures that your payments are only made after the exporters ship goods, which means you can keep your cash flow without any advance payment to exporters. It also proves your credibility to the seller.
For exporters, the L/C is just in case that if the importer cannot pay after you send goods. In this case, the bank will finish the payment, and the L/C can protect you from legal risks. It can be regarded as the guarantee of your capital to ensure the transaction is completed successfully.
How to Use the Letter of Credit to Make Transactions? (Letter of Credit Processing)
After understanding the basic concept of L/C, you may want to know more about how to use the letter of credit to make international transactions. This part will tell you the process of the Letter of credit in detail.
The whole process of the letter of credit mainly includes the following steps:
Step 1: Issuing a Letter of Credit
When both parties reach a trade agreement and sign the contract, the importer needs to apply for issuing a letter of credit to the issuing bank, which is in favor of the exporter. Then the L/C would be sent from the issuing bank to the advising bank. The latter one needs to verify the authenticity of the credit and send it to the exporter.
Step 2: Sending and Processing Documents
After receiving the credit, the exporter needs to check it and prepare the shipment of the goods according to the contract. The exporter creates and sends documents to the reimbursement bank. The bank sends and processes the documents to the issuing bank for claiming accordingly. In this step, confirming the bank may help it process.
Step 3: Make Payments and Notice Applicants
The issuing bank receives the documents from the reimbursement bank and makes the payments to it. Then it submits bills to the applicant and notices him retire documents.
Step 4: Take Delivery of Goods and Finish Payments
Then the applicants take delivery of goods with the documents. After that, the applicants finish payments to the issue bank.
Is the Letter of Credit Safe?
Compared to other international payments, like online transfers, the letter of credit is much safer and more reliable. The reason is that no less than two banks are involved in the transaction to provide services and ensure security and safety so that the transaction can be made successfully.
The covering range of L/C is wide around the world with less limitation of countries and regions. It can narrow the gap between importers and exporters to reduce trade risks and shorten the transaction time. So if your business scale is sizeable, you can trust L/C.
Advantages and disadvantages of the Letter of Credit
Due to the restrictions of different factors, like countries, regions and currencies, all the international payment methods have various benefits as well as shortages for users. This part explains the advantages and disadvantages of the letter of credit, and we hope you can know it better if it is the right one for you to choose.
Advantages of Letter of Credit
- It is safe and reliable for both parties, with various terms and agreement conditions.
- L/C makes transactions guaranteed by banks, helps cross-border transactions between both parties completed successfully.
- L/C reduces the uncertainty of payments from importers and makes exporters more responsible for goods.
- It is negotiable for both parties when they sign the contract and designate L/C as the payment method. Payment conditions can comply with the requirements and demands of both sides.
- If there is any trade dispute between both parties, L/C would help them solve the problem according to the credit agreement before.
- L/C can help develop business and trades established between new partners and expand their market.
Disadvantages of Letter of Credit
- This payment method is not suitable for a small amount of business.
- Compared to other payment methods, banks would charge higher fees. Extra services or functions of both parties require extra fees as well.
- The letter of credit has a period of validity. Within the period, both parties have to complete key parts of the transaction, which sometimes may create a mess.
- If there are any changes in conditions or terms of the L/C, the transaction needs to be delayed inevitably. It may be not quite flexible.
8 Types of Letter of Credit
According to various factors and demands of both parties, there are different types of letters of credit. This part will list several common types of L/C to help you know if the L/C or which type of it is suitable for your business and transactions.
According to the payment time, L/C can be divided into sight L/C and usance L/C.
Sight Letter of Credit (L/C at Sight)
This letter of credit means that the issuing bank or payee bank immediately makes the payment after receiving the documentary draft or the shipping document consistent with the credit terms.
This type of credit is much timelier compared to other forms of credit.
Usance Letter of Credit
Usance letter of credit (also acceptance credit or time credit) means that the issuing bank or the payee bank receives the documents of credit and then makes the payment with a limited period.
For example, the importer places an order with the exporter and receives goods in one day. The order bill would be delivered with the shipment of goods together. However, if the LC before sets a credit period of a month, the importers don’t need to pay immediately after receiving goods. It means that they can finish the payments within the period.
According to the responsibility standards of issuing banks, letters of credit are divided into two types.
Revocable Letter of Credit
This type of credit can be changed at any time by either the buyer (the importer) or the issuing bank without notification to the beneficiary. The changes include amending the terms or cancellation of the letter of credit completely.
There are many reasons for revoking the letter of credit. However, as buyers, you should remember that your reasons must be reasonable, or you would lose your credibility with the sellers invisibly.
Irrevocable Letter of Credit
The irrevocable letter of credit only allows change or cancellation by the issuing bank with the application by the buyer and approval by the beneficiary. Without the agreement of both parties, the issuing bank has no right to amend or cancel the credit.
Usually, this type of letter of credit is more common and used more widely than the revocable letter of credit; it can protect the interests of both sides balanced to avoid many troubles.
There are also other forms of the letter of credit used widely in common international transactions. Here will list 4 types for your reference.
Confirmed Letter of Credit
The confirmed letter of credit means that another bank (confirming bank) other than the issuing bank adds a guarantee to the letter of credit. It gives security that the confirming bank would make the payment in the transaction if the issuing bank fails to finish the payment.
Only the irrevocable letter of credit can be confirmed in transactions. If the exporter doubts the credibility of the first issuing bank, he can require the importer to get the confirmed letter of credit.
Unconfirmed Letter of Credit
The unconfirmed letter of credit means the credit with no other bank to give security or confirm but only the issuing bank. Usually, in cross-border transactions, this credit is used less than the confirmed letter of credit.
Transferrable Letter of Credit
The transferrable letter of credit means that the beneficiary (the first beneficiary) of the credit can be an intermediary for the sellers of goods or services, or be a group of suppliers, and he can present his credit documents and transfer part or all of the payment to the actual or second beneficiaries.
In this case, the issuing bank needs to indicate “transferable” clearly in the letter of credit, and the transfer is only allowed once.
Standby Letter of Credit
The standby letter of credit is used to ensure the payment commitment of the bank to the exporter when the importer fails to make the payment. It is not used for paying off the number of commercial transactions but for loan financing or debt repayment.
It is more likely to be a legal document, different from general business letters of credit.
We hope this article helps you understand import L/C and export L/C better. If you want to know more about international payment methods, you can find other articles on our website,
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