Glossary term
Letter of Credit
A letter of credit is a bank commitment to pay a beneficiary when the required documents and conditions are presented correctly.
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What Is a Letter of Credit?
A letter of credit is a bank commitment to pay a beneficiary when the required documents and conditions are presented correctly. It is commonly used in trade finance, construction, leasing, and other transactions where one party wants payment assurance from a creditworthy bank.
The bank's obligation is tied to documents, not to every detail of the underlying business dispute. If the documents comply with the letter of credit, the bank may be required to honor the payment request even if the buyer and seller disagree about performance.
Key Takeaways
- A letter of credit shifts payment risk to a bank under stated conditions.
- The beneficiary must present documents that comply with the letter's terms.
- Letters of credit are often used in international trade and commercial transactions.
- They can reduce counterparty risk but add fees, documentation, and strict timing rules.
- The bank reviews documents, not the entire commercial relationship.
How a Letter of Credit Works
A buyer or applicant asks a bank to issue a letter of credit in favor of a seller or beneficiary. The letter states what documents the beneficiary must present to receive payment. Those documents may include invoices, shipping documents, certificates, or other records specified in the agreement.
If the beneficiary presents conforming documents within the required time, the issuing bank honors the letter according to its terms. The applicant then owes the bank under the credit arrangement.
Common Parties in a Letter of Credit
Party | Role |
|---|---|
Applicant | Requests the letter of credit, often the buyer |
Issuing bank | Issues the payment commitment |
Beneficiary | Receives payment if documents comply |
Advising or confirming bank | May notify, authenticate, or add an additional payment commitment |
Costs and Documentation Risk
Letters of credit can make a transaction safer, but they are not frictionless. Banks charge fees, may require collateral or credit approval, and expect exact compliance with documentary terms. A small documentation error can delay or prevent payment.
Businesses should understand the letter's expiration date, presentation rules, required documents, shipping terms, and dispute procedures before relying on it for cash flow.
The Bottom Line
A letter of credit is a bank-backed payment mechanism based on document compliance. It can reduce counterparty payment risk, but only when the parties understand the required documents, fees, deadlines, and the bank's limited role.