A letter of credit, also known as a documentary credit, is a written commitment by a bank to pay the seller of goods or services up to a specified amount under specified conditions.
They are used in international trade to ensure that the buyer will pay for the goods they purchase. There are several types of letters of credit, and each one has its own specific purpose.
In this blog post, we will discuss the different types of letters of credit and what each one entails.
Commercial Letter of Credit
A commercial letter of credit is the most common type of letter of credit. It is used to finance the purchase of goods and services.
The terms and conditions of a commercial letter of credit are negotiable between the buyer and seller. When the buyer and seller have agreed on the terms, the buyer’s bank will issue the letter of credit.
The letter of credit will list the conditions that must be met in order for the payment to be released. These conditions may include proof that the goods have been shipped, an invoice and a bill of lading.
Once the seller has met all the conditions, they can present the documents to the buyer’s bank. The bank will then release the payment to the seller. Purchase Order Financing companies prefer this type of Letter of Credit for it’s transactional structure and bank support.
Standby Letter of Credit
A standby letter of credit is a guarantee that a buyer will be able to meet their financial obligations. They are often used as a form of security for loans and real estate transactions.
If the buyer defaults on their loan, the lender can present the letter of credit to the bank. Then, the bank will release the funds to the lender.
Standby letters of credit can also be used to guarantee payment in case of default on a contract. So, if a contractor is hired to build a house and they default on the contract, the homeowner can present the standby letter of credit to their bank. The bank will then release the funds to the homeowner.
Transferable Letter of Credit
A transferable letter of credit allows the beneficiary to transfer all or part of the credit to another party. This type is usually used when there are multiple suppliers involved in a transaction.
For example, if a company is buying parts from multiple suppliers to assemble a product, they can use a transferable letter of credit. The company can then transfer the credit to each supplier. This ensures that each supplier will be paid for the parts they supplied.
Revocable Letter of Credit
A revocable letter of credit can be canceled or amended by the issuing bank without the consent of the beneficiary. This is not commonly used because it creates a lot of risk for the beneficiary.
If the issuing bank cancels or amends the letter of credit, the beneficiary may not be paid. For this reason, most letters of credit are irrevocable.
Irrevocable Letter of Credit
In contrast with a revocable letter of credit, an irrevocable letter of credit cannot be canceled or amended by the issuing bank without the consent of the beneficiary. This is the most common type of letter of credit because it provides more security for the beneficiary.
When the terms of an irrevocable letter of credit are not met, the beneficiary can still present the documents to the bank and receive payment.
Revolving Letter of Credit
A revolving letter of credit is a letter of credit that can be used multiple times. The credit limit is typically renewed when the outstanding balance is paid off.
This is often used for businesses that have seasonal fluctuations in their inventory. For example, a clothing store may have a revolving letter of credit that they use to purchase inventory for the winter and summer seasons.
Red Clause Letter of Credit
A red clause letter of credit is a letter of credit that allows the beneficiary to receive an advance payment. The advance payment is typically 50% of the value of the shipment.
The advance payment can be used to cover the cost of materials or other expenses associated with the shipment. Once the shipment is delivered, the buyer will pay the remaining 50% of the value of the shipment.
As you can see, there are many different types of letters of credit. Each has its own purpose and use. When choosing a letter of credit, be sure to choose the one that best suits your needs.
Now that you know the different types of letters of credit, you already have an idea on which one is right for your business needs. If you have any questions, be sure to speak with your bank or financial advisor.