Letters of credit is basically a certificate issued by a bank that assures payment. But how does it work exactly? Reading through the following article you will find all you need to know about this method. We will describe what it is and why it is useful for safe business transactions. Besides we will explain how it works, how it is documented and what the money moving process is about.
Letters of Credit and its Many Names
Letters of credit or LOC have several names. Besides the primary name, bankers commercial credit or documentary credit are also used to refer to this payment method. This procedure is a safe way to conduct international commerce assuring both parties of financial security.
A Letter of Credit in an International Trade Transaction
The letter of credit can be used as the primary means of payment in international trade transactions. This is because it is an economically safe and trusted method of trading among both parties assured by their banks.
A Letter of Credit is Irrevocable
A letter of credit is a document from a bank that guarantees payment. This document is irrevocable in order to assure security for both parties. There are several types of letters of credit, and they can provide security when buying and selling products or services.
Why does the Seller Require a Letter of Credit?
LOC is fundamentally a letter in which a bank guarantees that the buyer’s payment will actually be received by the agreed deadline and for the right amount. Therefore it is safe to say that the primary reason for the seller to want a letter of credit is security.
A Guide on How it Works
1. Decide to Do a Letter of Credit !
2.Issuing the LOC
- How much will the payment be exactly?
- All of the contact information of the seller (also known as the beneficiary).
- When will the goods provided by the seller be delivered to the buyer exactly?
- In what way will the seller ship the product?
- The exact location where the shipment should arrive.
The more terms and conditions are expressed and elaborated, the better it is. In addition, it is also important to entail everything the parties might want to have included in their business transaction.
The Money Behind a Letter of Credit
The money behind the LOC is supposed to come from the buyer of course. For this reason, before agreeing to issue the document, the bank will want to be absolutely sure that the buyer can pay for their purchases. At times, the buyer is required to pay to the bank before the trade and allow the bank to hold the money until the trade happens.
The Money Behind a Letter of Credit
- Shipping the goods by a certain date
- Having the goods inspected before shipment
- Using the shipping method specified in the Letter of Credit
- Shipping exactly to and from ports specified in the document.
- Collecting the required documents listed in the LOC (specific shipping documents, for example)
- Submitting documents to the bank by a specific deadline
- Check each of the terms and conditions before making a decision and saying yes to the agreement.
- Be clear about all of the documents needed. If anything is not perfectly clear, reach out to your bank.
- It is important and easy to get the required paperwork in order to get the Letter of Credit.
- Know the limitations regarding this mechanism and if they are rational and fitting to your needs.
- Get information regarding the time frame within which your suppliers would provide you the documents required.
- Be sure to return the documents to your bank before the deadline stated in the agreement.
- Verify all documents needed by the Letter of Credit and see if they match with the Letter of Credit application exactly. Even typos, or common substitutions can result in issues.