What is a Letter of Credit (LC)? Meaning, Full Form & How It Works

In business, especially international trade, buyers and sellers may operate in different countries, follow different legal systems, or have no previous trading relationship. A letter of credit can reduce payment risk by giving the seller a bank-backed payment undertaking, provided the documents submitted meet the terms of the credit. 

For the buyer, an LC can make it easier to trade without paying the full amount before shipment. For the seller, it provides greater payment assurance than relying only on the buyer’s promise to pay. However, banks examine the documents required under the LC; they do not inspect or guarantee the quality of the underlying goods. Read on to understand the meaning, process, documents, types, charges and application steps. 

Letter of Credit Meaning 

LC full form is Letter of Credit. 

A letter of credit is a formal undertaking issued by a bank or financial institution, usually at the request of a buyer (the applicant), in favour of a seller (the beneficiary). The issuing bank agrees to honour payment when the beneficiary presents documents that comply with the terms and conditions stated in the LC. 

Letters of credit are commonly used in domestic and international trade where the parties want greater payment certainty. The LC is separate from the underlying sale contract, and the bank’s decision to honour it is based on the required documents rather than the physical goods or services themselves. 

How Does a Letter of Credit Work? 

A typical letter of credit transaction begins after the buyer and seller agree that payment will be made through an LC. The buyer applies to an issuing bank, which assesses the buyer’s creditworthiness and may ask for a margin, collateral or other security depending on the facility and the bank’s policy. 

Once approved, the issuing bank sends the LC to an advising bank, usually in the seller’s country. The seller reviews the terms and, if acceptable, ships the goods and prepares the documents required by the LC. These may include the commercial invoice, transport document, packing list, certificate of origin and other specified records. 

The seller presents the documents through the relevant bank. The banks examine the presentation against the LC terms. If the documents comply, the issuing bank honours the LC according to its payment terms, such as sight payment or deferred payment. The buyer then reimburses the issuing bank as agreed and receives the documents needed to take delivery of the goods. 

Importantly, the bank does not normally take possession of or verify the goods. Its role is centred on the documentary presentation and the payment undertaking. 

Documents Required for a Letter of Credit 

There is no single document list for every LC. Requirements depend on the transaction, product, country, transport method, bank policy and wording of the credit. Common documents can be grouped into two categories: 

Documents the buyer may need when applying for an LC: 

• Completed LC application or trade-finance request form 

• Sales contract, purchase order or pro forma/commercial invoice containing the agreed trade terms 

• KYC and business documents required by the issuing bank 

• Import/export or regulatory documents, where applicable 

• Margin, collateral or security-related documents if required after the bank’s credit assessment 

Documents that may be required from the seller for payment under the LC: 

• Commercial invoice 

• Bill of lading, airway bill or another applicable transport document 

• Packing list 

• Certificate of origin 

• Insurance policy or certificate, where applicable 

• Inspection, quality, weight or quantity certificate, if stipulated 

• Bill of exchange, if required 

• Other licences, declarations or regulatory documents specified in the LC 

The exact list should be confirmed with the issuing bank and matched carefully to the LC terms, because missing or inconsistent documents can lead to discrepancies and delay payment. 

Types of Letters of Credit 

Some commonly used types of letters of credit include: 

1. Sight Letter of Credit: Payment is made after the beneficiary presents complying documents and the bank completes its examination. 

2. Standby Letter of Credit: Acts mainly as a backup payment undertaking and is generally invoked if the applicant fails to meet the specified obligation. 

3. Usance or Deferred Payment Letter of Credit: Payment is due at a future date or after an agreed credit period rather than immediately on presentation. 

4. Irrevocable Letter of Credit: Cannot be amended or cancelled without the agreement required under the applicable LC terms and rules. Under UCP 600, a documentary credit is irrevocable. 

5. Confirmed Letter of Credit: A second bank adds its own undertaking to that of the issuing bank, giving the beneficiary additional payment assurance. 

6. Transferable Letter of Credit: Allows the first beneficiary to request transfer of all or part of the credit to a second beneficiary when the LC expressly states that it is transferable. 

A “revocable LC” is a legacy concept and should not be treated as the standard form under UCP 600, which defines a credit as irrevocable. 

How to Apply for a Letter of Credit? 

The exact process varies by bank and transaction, but a typical LC application and settlement flow is as follows: 

1. Agree on the sales contract: The buyer and seller finalise the price, goods or services, shipment terms, payment terms and the decision to use an LC. 

2. Apply to the issuing bank: The buyer submits the LC application along with the commercial terms and supporting documents required by the bank. 

3. Complete the bank’s assessment: The issuing bank reviews the buyer’s credit profile, transaction details, available limits and any margin or security requirement. 

4. LC issuance and advising: After approval, the issuing bank issues the LC in favour of the seller and sends it to the advising bank, which authenticates and advises it to the seller. 

5. Seller reviews and ships: The seller checks the LC terms and, if acceptable, ships the goods or performs the agreed obligation within the stipulated period. 

6. Present and examine documents: The seller submits the required documents through the nominated, advising or confirming bank, as applicable. The banks examine them for compliance with the LC terms. 

7. Payment and document release: If the presentation complies, the LC is honoured according to its terms. The issuing bank obtains reimbursement from the buyer as agreed and releases the relevant documents so the buyer can claim the shipment. 

Before applying, the buyer should confirm that the LC wording matches the underlying commercial agreement and that all documentary requirements can realistically be met. Even small discrepancies can lead to delays, amendment costs or refusal of a presentation. 

Charges and Fees for a Letter of Credit 

There is no single fixed charge for a letter of credit. The total cost depends on factors such as the LC amount, validity or tenor, the applicant’s credit profile, transaction structure, countries and banks involved, and whether additional services such as confirmation are required. 

Common LC-related charges may include: 

• Issuance or opening commission 

• Advising charges 

• Confirmation charges, where a confirming bank adds its undertaking 

• Amendment charges for changes after issuance 

• Document examination or handling charges 

• Negotiation, payment or reimbursement charges 

• Acceptance or deferred-payment charges for usance LCs 

• SWIFT or other communication charges 

• Discrepancy fees where documents do not comply 

• Foreign-exchange conversion costs and applicable taxes 

The buyer and seller should also agree who will bear the issuing bank, advising bank, confirming bank and overseas bank charges. Always refer to the bank’s current schedule of charges or written sanction terms rather than assuming a standard percentage. 

Understanding how a letter of credit works can help businesses reduce payment uncertainty in transactions where the buyer and seller need additional assurance. The key is to agree on practical LC terms and ensure that every required document matches those terms. 

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FAQs on Letter of Credit (LC) 

1.Why is it called a letter of credit? 

It is called a letter of credit because the issuing bank provides a written credit undertaking in favour of the beneficiary. The bank agrees to honour payment when the beneficiary submits documents that comply with the LC terms. 

2.What is the difference between LC and BG? 

A letter of credit is generally used as a primary payment mechanism: the bank honours payment against a complying documentary presentation. A bank guarantee is more commonly a secondary or default-based undertaking that may be invoked when a contractual obligation is not fulfilled. The exact legal effect depends on the wording of the instrument. 

3.What is the process of LC? 

The buyer and seller agree to use an LC, the buyer applies to the issuing bank, and the bank issues the LC in favour of the seller. The seller ships the goods and presents the required documents. If the documents comply with the LC terms, the bank honours payment according to the agreed sight or deferred-payment terms. 

4.What is the full form of LC? 

LC stands for Letter of Credit. It is a bank-issued payment undertaking commonly used in trade transactions to provide the seller with payment assurance against a complying documentary presentation. 

5.How much does a letter of credit from a bank cost? 

There is no universal LC fee. Costs vary by the LC amount, tenor, type, applicant’s credit profile and banks involved. Charges may include issuance, advising, confirmation, amendment, document-handling, SWIFT, discrepancy, foreign-exchange and applicable taxes. Check the issuing bank’s latest tariff or sanction terms for the actual cost.