How Does Letter of Credit (LC) Work? All You Need To Know

  • Published on: 18 Dec 2023
How Does Letter of Credit (LC) Work? All You Need To Know

In businesses, a letter of credit (LC) from a bank has great importance in building trust and continuing trading even when you are short on funds. This document is especially useful in international import and export transactions when partnering with a new seller. 

Getting an LC from your bank gives the seller a proof of guarantee for payment, which allows you to get credit for your supplies. To know more about LC and its benefits, read on.

Letter of Credit Meaning

A letter of credit (LC), generally given by a bank, acts as a guarantee or an affirmation for the seller that the buyer will make the payment on time and in full. If the buyer fails to pay the seller, the responsibility then lies with the bank that issued the LC. 

Generally, LC is a requirement for transactions involving the import and export of goods where the respective parties don’t know each other.

Also Read: What is Loan Closure Certificate?

How Does a Letter of Credit Work? 

When the bank issues an LC, it takes possession of the goods until the buyer makes the complete payment. In case the buyer cannot make the payment immediately, they can enter into a line of credit with the bank. Thus, the issuing bank will make the payment to the seller and enter into a loan agreement with the buyer. 

However, to get an LC, the buyer must provide relevant collateral and pay the fees for documentation. Since it is also a negotiable instrument, the issuing bank will pay on the buyer’s behalf to the seller or any other bank nominated by them. In case the LC is transferable, the seller may choose a third party or another entity to receive the payment. 

Types of Letters of Credit

Now that you know what is a letter of credit, here are the different types of LCs a bank issues:

  • Credit on Sight: This allows the seller to receive payment immediately with the relevant documents
  • Standby Letter of Credit: Here, the banks make payment to the seller only when the buyer fails to do so
  • Time Credit: Under this LC, the bill will only clear after a certain time period
  • Revocable Credit: The issuing bank to amend or cancel the terms of credit at any time without informing the beneficiaries  
  • Irrevocable Credit: This LC cannot get cancelled or altered without the agreement from all the parties

How to Apply for a Letter of Credit?

To apply for a letter of credit, you can follow these steps: 

  • Step 1: Choose a bank that meets your requirements
  • Step 2: Provide necessary documents to the bank to create a sales agreement
  • Step 3: Fill in the application form for an LC
  • Step 4: Pay the fee and await the approval

Remember to negotiate the terms of your purchase and LC to ensure that it is suitable for your requirements. Also, choose a bank that has experience in issuing LCs and in international trade, as well as a good network of correspondents.

Knowing the attributes of a letter of credit (LC) can help you receive your payment on time and in full from your client. If you are unable to source funds to meet business requirements, there’s always another option: getting a personal loan. With Fibe’s Instant Personal Loan, you can tackle unexpected and planned finances seamlessly. 

You can get a credit of up to ₹5 lakhs at affordable interest rates with minimal documentation by meeting some simple eligibility criteria. Download the Personal Loan App or visit our website to get started on your application. 

FAQs on Letter of Credit (LC)

Why is it called a letter of credit?

A letter of credit (LC) provided by a bank acts as proof or a guarantee to the seller that the buyer will pay the purchased amount. Therefore, it allows you to avail of the goods or services on credit and a payback later.

What is the difference between LC and BG?

An LC is a document that guarantees payment for goods and services on behalf of one party to another. Bank Guarantee (BG), on the other hand, promises the lending institution will pay on behalf of the debtor in case they are unable to do so. 

Furthermore, bank guarantees are common in real estate projects, while LC is common in international transactions. 

What is the process of LC?

To get a letter of credit (LC), a buyer will apply for one with a bank of their choice. They will then provide the required documents and collateral to the bank, which will issue the LC in favour of the seller upon verification. Depending on the type of LC issuer, the seller will receive the amount from the buyer or the bank.

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