A letter of credit is a written promise by a bank to pay for goods a buyer purchases from a seller. Discounting is a way a seller gets paid immediately even if the buyer wants a longer term for payment.
Letter of Credit
Sellers may request that a buyer obtain a letter of credit from a financial institution prior to shipping goods. This is done to protect the seller against nonpayment for the merchandise. This letter states the bank will pay the seller if the buyer defaults.
Often a buyer does not want to pay for the goods immediately after receiving them. The seller may not like this idea and would rather receive payment immediately. In this case, the seller may work with the guaranteeing bank and ask for a discounted payment.
How It Works
If the seller wants immediate payment, but the buyer doesn’t want to pay immediately, the bank may offer to pay the seller for the goods. The bank then pays the seller the full amount of the invoice minus a discount. According to Musson Freight, the discount is generally between 6 percent and 15 percent of the total bill.
Discounting benefits all three parties involved. The seller receives payment immediately, the buyer receives goods sought, and the bank—when paid by the buyer—receives a premium.