HomeCommercial TermsWhat is a Letter of Credit - How does LC works?

What is a Letter of Credit – How does LC works?

A letter of credit (LC) is a letter given by the bank guaranteeing that the buyer's payment will be received on time with the correct amount to the seller. In case the buyer is unable to pay, the bank pays to the seller on the buyer's behalf.

When you talk about starting an import-export business and making it a successful one the first thing which comes to mind is finance! For people involved in the import & export business, they must know what is a Letter of Credit(LC) and how does a Letter of Credit works?

A letter of credit which is commonly referred to as an LC is a letter given by the buyer’s bank with a guarantee that the buyer’s payment will be received by the seller of the goods within the stipulated time and certainly with the exact correct amount agreed upon to the seller. In case the buyer for some reason is not able to pay the seller then the buyer’s bank pays the seller as per the LC agreement on the buyer’s behalf.

What is a letter of credit?

The Letter of Credit also known as Credit Letter or LC has become one of the important and popular financial documents while doing any international trade.

The letter of credit is a guarantee by the bank or any financial institute that the payment of buying goods or services will be received on time and of the correct amount.

If the buyer of the goods or services is not able to make the payment as per the contract. The guaranteeing bank or financial institute will be liable to pay the remaining or full amount.

How does a letter of credit work?

Due to the distance in the import-export business or in the general trading business, every buyer and seller can not trust each other either for the payment or the goods. They should definitely hedge or have some security like a bank guarantee or insurance.

That is why most buyers and sellers higher an intermediate like a Bank or Financial institute or any well-established corporates and NBFCs. They guarantee that the full payment for the transaction of goods or services will be released at the time which was agreed by both parties.

If the buyer or seller is short on its commitment as per the contract the affected party is liable for the compensation which has already been guaranteed by the intermediate.

Types of letter of credit

At first look, this letter of credit may look like simple work. However, there are a lot of complex procedures and different types of LC. But you need not worry because EXIMPEDIA simplifies all the technical jargon, terminologies, procedures, documentation, application process, tips, and tricks of the import-export industry.

Different types of businesses demand different guarantees. Let’s take a look at types of letters of credit in the import-export business –

Commercial LC

The commercial letter of credit is a direct payment method in which the bank which issues the letter of credit will make the payment directly to the beneficiary.

Export/Import LC

Import and export letter of credit is one of the common types of LC which People involved in Import And export business use. It provides several guarantees of successful transportation etc.

Transferable LC

The transferable letter of credit is highly popular among people who are not the exact seller but an intermediary. The transferable letter of credit can be transferred 100% or a few parts of it to other beneficiaries also.

Un-transferable LC

Opposite to the transferable letter of credit the untransferable lateral credits can’t be transferred to any other person. The recipient of the untransferable letter of credit is the only person who can successfully receive the payment

Revocable LC

A Revocable Letter of credit is one of the least popular letters of credit out there. The issuing bank or the buyer can alter the contract anytime without notification which is not in the favor of the seller/ Beneficiary.

Irrevocable LC

An Irrevocable letter of credit cannot be altered like a Revocable letter of credit without the permission of all the parties involved in the whole process.

Standby LC

Completely opposite to the commercial letter of credit, the standby letter of credit is the backup payment method. If the buyer is not able to make the payment then a Standby Letter of Credit will cover all the things.

Confirmed LC

The confirmed letter of credit is like a guarantee to the seller by a second bank. If the primary bank which issued the first letter of credit is not able to pay then the second bank will do the work.

Unconfirmed LC

In general day-to-day business, most of the letter of credit are an unconfirmed letter of credit, in which there is no secondary or backup bank involved.

Revolving LC

A Letter of Credit is called a Revolving letter of credit if only one Letter of Credit is issued for multiple transactions.

Back to Back LC

The back-to-back letter of credit involves two different beneficiaries. Bank of the buyer will issue a letter of credit in the name of the intermediary. And the bank of the intermediary will issue the Letter of Credit for the seller.

Red Clause LC

If the letter of credit is a provision of paying advance before the goods or services are shipped then it is called a Red Cloud letter of credit.

Green Clause LC

Similarly to the red clause Letter of credit, the green Clause letter of credit also issue an advance payment but if the seller can provide the proof of goods

Sight LC

If a letter of credit Requires any submission of documents in front of the bank for the payment, then it is called a sight letter of credit.

Deferred Payment LC

If buyer and seller agree on a delayed payment It is called deferred payment of the letter of credit. At the time of the payment, the bank may also demand a few documents.

Direct Pay LC

In a direct-pay letter credit, the bank that is guaranteeing the payment will directly issue the payment to the beneficiary and then later ask the buyer to pay.

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