The Importance of Letters of Credit

Companies and laypeople often do not have the capital they need to fund projects or make large purchases on their own. They have to turn to credit in order to secure the financing they need. Letters of credit are letters that banks issue to verify the credit a business or person has. They are useful because they tell sellers that the bank will back the buyer in the event the buyer can't pay on his own.

The primary purpose of a letter of credit is to guarantee payment. Although the conditions of a letter of credit may vary based on your situation and the bank's regulations, letters of credit essentially let you capitalize on the bank's credit instead of relying on your own. The seller knows that if you don't come through with funds, the bank will. This promise to pay is vital for establishing new business relationships.

Financial institutions often describe letters of credit as beneficial to the seller, since they guarantee payment. However, letters of credit also ensure that the bank will act on behalf of the buyer; they keep payments from being made until the buyer can confirm shipment. This helps the buyer avoid scams.

In general, people use letters of credit for international trade. This is because people may be less familiar with companies, sellers and banks the farther away they are. It also is harder for effective communication to take place in international trade, although technology greatly is improving communication difficulties. Letters of credit also are useful for any domestic transactions where the buyer and seller have not worked with each other previously.

A letter of credit works on the basis that the seller will trust the issuing bank to cover payments if the buyer cannot do so. This means that a letter of credit may be harder to use if the issuing bank has not been established long enough to have a solid reputation.

There are different types of letters of credit. These include confirmed, commercial, irrevocable, revocable and standby. Each of these letters of credit has different terms, so one may be more appropriate for you than another depending on your situation. Your attorney or bank can advise you on which type would suit your needs best.