A letter of credit acts as an instrument buyers and sellers use in their business transactions. There are always risks in buying and selling. Most typically when you do not know the organisation you’re dealing with so well. Besides that, even when you have some level of trust in a buyer or seller. Unforeseen circumstances can pop up and totally district your arrangements, which can cost you financially. The meaning of letter of credit, how it works, and the process are all-inclusive in this article.
What is a letter of credit?
A letter of credit is a letter that a bank writes guaranteeing timely payments by the buyer to a seller. Besides that, the bank assures that the payment will be complete. They also call a letter of credit ‘credit letter.’
However, if the buyer cannot pay upon purchase from the seller. They will require the bank to cover the full payment or the remaining amount of the purchase. They could offer this as a facility to the bank.
It has become a really important aspect of international trade. Because of international dealings with factors such as distance, and different laws in those countries.
How does it work?
A letter of credit acts as instrument buyers and sellers use in their business transactions. Here, the issuing bank will pay the beneficiaries or the bank they select. But if it is transferable, the beneficiaries may select another receiver they wish. And this could be by giving a third party or a corporate parent the right to draw.
Banks charge a service fee for writing this letter and this charge could be as a percentage of the size of the letter. In international transactions, the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees the letters of credit process.
What are the types of letters of credit?
The knowledge of types of letters of credit will help you know the right one you could use. Besides that, it will also help you understand what you are working with.
The following are some types:
1. Commercial Letter of credit
They also call this type of letter of credit ‘Documentary credit’ or an ‘Import/ export letter of credit.’ Here, the bank plays the role of a neutral third party to release funds. Once they meet all the conditions of the agreement.
2. Standby Letter of credit
This type of credit provides compensation, especially when unforeseen circumstances happen during a transaction. It enables payments if something happens along the way or cannot happen.
There is a bit of similarity between the commercial letter of credit and the standby letters of credit. However, they can only activate them only if the beneficiaries can prove that their agreement has default.
Overall, standby letters ensure beneficiaries receive their payments. Besides that, they also guarantee that services will occur satisfactorily for all the parties in the agreement.
3. Irrevocable Letter of credit
You cannot change the irrevocable letter with the authorization of all the parties in the agreement. Revocable letters don’t have the security that most beneficiaries need. Because of this, almost all letters of credit now are irrevocable.
4. Revolving Letters of credit
Buyers use this type of letter often because it allows them to do business repeatedly.
Therefore, this type helps buyers to make multiple payments. Besides that, it relieves them of the stress of getting a new letter for each transaction. The validity of this letter can be up to three years or fewer.
A bank in Ghana offers letters of credit for buyers in Asia, Eastern Europe, Australia, and the Middle East who may have difficulty getting international credit on their own. The Ghanaian bank’s letters of credit process help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk.
They typically provide these letters within two business days. Therefore, guaranteeing payment by the confirming Ghana bank’s branch. This specifically benefits a client in a potentially unstable economic environment.
How can I get a Letter of credit?
After seeing some of the types, you might want to know how you can get one. However, contact your bank for one. For this to happen, you might need to meet an international trade department or commercial division. This is because not all financial institutions offer letters of credit. But some banks around you can easily direct you to where you can get it.
How does it work in international trade?
In international trade, the letter of credit process comes into reality. This is because importers and exporters use them regularly to protect their transactions. The risks of working with people from other countries that you don’t know too well can be risky. Most times, a buyer from overseas might have good intentions to make payments on time. But because of some constraints, like political unrest or business troubles can delay payments.
Because of the different time zones, languages, etc communication could become difficult. Therefore, the letter help makes the details of the agreement clear to everyone from now on. Minimizing the room for uncertain assumptions among the parties.
Also read up and understand what is a lease?
What must I consider before getting a letter of credit?
A letter of credit backs up your business transactions should unfortunately fall apart. It reduces the risks you encounter in business and ensures the continuation of your business. Therefore, in order to enjoy the benefits of the letter, there are things you must consider.
The following are the things you must consider before getting a letter of credit:
- Review all the requirements for the letter carefully before you agree to the deal
- Ensure you have a full understanding of all the documents and ask your bank questions when you are not following
- Ensure you can get all the documents you may need for it
- Know the time limit that comes with the letter and know whether they are cool for you
- Know how fast your service providers or shippers will produce documents for you
- Make thorough verification of all documents they require for the letter and match them to the letter of credit application as they require it. Avoid typographical errors or common substitutions because they can cause problems during the application.
With the letter of credit, the path for international trade will always be free from hindrances. Because of this, sellers have little or nothing to fear regarding timely payments for business transactions from the buyers. Whereas the buyers will have little or no fear about adequate delivery of goods and services, they pay for.