Letter of Credit: Pros & Cons

Before credit cards and traveler's checks came into common use, many merchants and individuals used letters of credit as financial backing for their sales and service transactions when dealing with unknown customers or merchants. Letters of credit are still in use, and provide a number of advantages. However, letters of credit also have drawbacks, some of which are significant.

A bank issues a letter of credit to guarantee payment made on the behalf of a named beneficiary, often a business or merchant customer of the bank. When used for commercial transactions, letters of credit serve a similar function as a line of credit or an account with a specified payment date, such as net -15--payment within 15 days--or net -30--payment within 30 days. Banks may also issue letters of credit to prominent citizens whom they trust to make good on their financial obligations. Letters of credit allow individuals to travel without carrying large sums of cash.

Letters of credit take several forms, which differ in some functions depending on the specific type. A letter of credit may be primary--that is, it serves as the main method of payment--or secondary, which means that the letter of credit serves as a backup in case the beneficiary fails to pay. A confirmed letter of credit is issued by a foreign bank and guaranteed as valid by a domestic bank. A commercial letter of credit guarantees payment for goods to a seller delivered to the bearer of the letter upon presentation of satisfactory documentation by the seller. An irrevocable letter of credit guarantees payment by the issuing bank as long as the beneficiary meets the terms specified in the document, as opposed to a revocable letter of credit, for which a bank may modify or cancel payment.

Letters of credit also cover special circumstances. Transferable letters of credit allow the original beneficiary to transfer the letter of credit and its guarantee of payment to a third party, who then becomes the beneficiary. Deferred payment letters of credit specify payment after a specific time has passed. A back-to-back letter of credit uses the first letter of credit as collateral for a second letter of credit, which the beneficiary issues to the actual supplier of merchandise or service. A red-clause letter of credit advances cash to the seller in advance of actual delivery of merchandise or services. A revolving line of credit allows the beneficiary to draw on the specified amount of credit for a specified number of times; the issuing bank restores the credit to the original amount after each transaction.

The main advantage of a letter of credit is that it eliminates the need for up-front cash payments. However, sellers may encounter problems with letters of credit, such as impossible delivery schedules or unacceptable costs. Attempts to modify the terms of a letter of credit may also cause disruptions in the transaction. Discrepancies in the documents presented by the seller may also cause the issuing bank to void the letter of credit, according to the Credit Research Foundation.