The Letter of credit is a guarantee document that assures the seller about the buyer’s credit. Usually, the bank issues a letter of credit on behalf of the buyer. A guarantee from the bank regarding the payment ensures that the seller will get their dues from the bank even if the buyer fails to make the payment. Therefore, the Letter of credit is also known as the credit document.
Importance of the Letter of credit
Letter of credit is important not only for the buyer but also for the seller. It ensures the seller that he/she will get his dues irrespective of the circumstances, and it also increases the buyer’s creditworthiness. Letter of credit aids in making the business transaction more fruitful.
Types of Letter of credit
Following are the types of letters of credit:
- Credit on sight:
It is an instant letter of credit. This buyer immediately gets cash for the transaction by showing the Letter of credit on sight. A letter of credit on sight is provided after providing the correct documentation.
- Time Credit:
This allows the buyer to make payment after receiving the goods at a certain point. Letter of time credit mentions when the buyer will make the payment. Some time credit letters allow a grace period for the buyer to make a payment.
- A standby letter of credit:
A standby letter of credit or the SBLC is a credit instrument that allows the seller to get foreign currency if the buyer has issued a standby letter of credit. Buyers do not need to contact the international bank for issuing SBLC. Domestic banks can also issue a standby letter of credit on the guarantee of the payment to the international bank.
- Revocable credit:
A revocable letter of credit allows banks to make changes or amendments in the letters. Banks are not obliged to inform both parties about the revocable Letter of credit changes. Banks can also cancel the revocable Letter of credit without informing both parties.
- Irrevocable credit:
An irrevocable letter of credit is obligatory for the banks towards the terms and conditions mentioned in the Letter. Banks can not make amendments or cancel the irrevocable Letter of credit on their own.
- Transferable credit:
Transferable letters of credit may be transferred to a third party after consultation with the original two parties. Terms and conditions mentioned in the original Letter of credit can vary as per the third party’s wishes.
How does a Letter of Credit Work?
Step one:
Applicants need to visit the bank known to issue a letter of credit and initiate the process.
Step two:
An advising bank that is primarily international will verify all the information such as name, product details mentioned in the Letter of credit. It is the responsibility of the advising bank to confirm the authenticity of the Letter of credit.
Step three:
Once the Letter’s authenticity is confirmed, the advising bank will inform the seller about the Letter of credit by providing the document of the Letter of credit that assures sellers that/her due payment will be paid as banks are now part of the transaction.
Step four:
Seller will receive the bill of products dispatched, or the receipt of the products landing after the seller is assured from the bank about the payment.
Step five:
After the delivery of the products, the buyer will inform the advising bank about the products. Advising bank will further verify whether the products and the delivery are as per the instructions. Once everything is verified and the bank is satisfied with it, it will issue the payment to the seller on behalf of the buyer.
Step six:
Advising bank will then provide all the shipping and delivery documents to the issuing bank and demand the payment.
Step seven:
After getting demand from the advising bank, the issuing bank will provide all the documents to the buyer for verification.
Step eight:
Now, the buyer will make payment to the issuing bank to conclude the process of a letter of credit.
What are the documents required for issuing a letter of credit?
Following are the documents that banks require to issue a letter of credit:
- A completed application form with passport-sized photographs is required.
- The applicant, co-applicants, partners, and directors must all pass a background check (Passport, Voter ID card, Aadhar Card, Driving License, etc.)
- Exchange Bill (Bill of Exchange)
- Invoice for Commercial Use
- Origin Certificate
- Original health and insurance certificates
- Financial Documents of the Buyer
- Documents for packing, shipping, and transportation
- Airway bills, freight receipts, and so forth.
- Certificate of Inception and Related Commercial Documents
- Documents necessary by the buyer’s or seller’s nation
- Any other documents that the lender requires
FAQs
What is the fee on the Letter of credit?
The fee on the Letter of credit varies from institution to institution. In addition, factors such as the risk involved in the transaction can affect the fee.
Is a letter of credit suitable for international transactions?
Yes. The Letter of credit is most suitable for international transactions. This is because a buyer gets more time accumulating the required funds for the payments.
Is there a time limit on the transaction?
Yes. When the bank issue the Letter of credit, it comes with an expiry date. If the goods are not delivered within the time frame, the banks can take action against the party.
Do we have to abide by all the clauses mentioned in the Letter of credit?
Yes. We have to abide by all the clauses mentioned in the Letter of credit, as it is a legally binding document. However, both parties get their say while drafting the Letter to change or add any clause they think is suitable.
What types of collateral can be provided for issuing the Letter of credit?
Buyers can put/her active finances or fixed deposits when issuing the Letter of credit as collateral.
Can a letter of credit be canceled?
In most cases, a letter of credit cannot be canceled without informing both parties.
Is a letter of credit safe?
Yes. Letter of credit is safer for international payment transactions.
Can a low CIBIL score affect the Letter of credit?
A low CIBIL score can affect the Letter of credit to a certain extent. However, if you provide collateral, you can issue a letter of credit.
Is there is any risk involved in the Letter of credit transaction?
Yes. Risks like low-quality goods, return options and other risk factors are present in the Letter of credit.
How long does it take to issue a letter of credit?
Usually, it takes around 10-15 business days from the initiation of the process to issue the Letter of credit.
