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What is a letter of credit?

A letter of credit is a legal document issued by a bank, lender, or other financial institution that guarantees payment to a vendor. The guarantor of the credit letter acts as an impartial third-party intermediary that is pledging to cover the cost of the purchased products, services, or shipping in the event the borrower does not pay. The letter of credit is beneficial to all parties involved because it minimizes the risk of non-payment and functions like an escrow account. When a buyer can provide a letter of credit, the issuing bank is confirming that their credit history and available cash flow are sufficient to cover the purchase.

Conditions of a credit letter

Applications for a letter of credit typically require some form of collateral to secure the letter. Collateral is typically a tangible fixed asset, like real estate or equipment, but may also be an intangible item like investments or personal finances. Future paychecks, cash, and a business’s accounts receivables can also be used as collateral. A lender’s claim to a borrower’s collateral is called a lien—a legal right or claim against an asset to satisfy a debt. The borrower has a compelling reason to repay the loan on time because if they default, they stand to lose their home or other assets pledged as collateral.

Required participants

While a letter of credit sounds like a simple document, there are several individuals and organizations involved with the issuance of this type of guarantee.

  • Borrower – The borrower, or applicant, applies for a letter of credit with the lender. The applicant is responsible for providing any necessary documents to prove they have the means to make the payment.
  • Beneficiary – The seller of the product or service that is requiring the guarantee is the beneficiary in a letter of credit transaction. Once the transaction is completed, they will become the recipient.
  • Issuing bank – The bank, credit union, creditor, or financial institution that receives and reviews the borrower’s application is called the issuing bank. In the case of a transaction involving a seller and buyer in different countries, the issuing bank is typically located in the same country as the borrower.
  • Negotiating lender– The negotiating lender works with the issuing lender, on behalf of the seller, to make sure the final payment is made. The negotiating lender may also be referred to as the advising bank.
  • Confirming institution – Once the borrower has met the conditions of the letter of credit, the confirming lender guarantees the payment to the beneficiary. The confirming bank may be the same institution as the seller’s negotiating bank, or it may be an additional third-party lender.
  • Freight forwarder – For international processes where shipping is necessary, the freight forwarder handles the logistics of shipping the products.
  • Attorney – Either the borrower or the beneficiary may choose to consult legal counsel when conducting deals with a letter of credit in lieu of payment.

Types of letters of credit for small businesses

The type of letter of credit that is right for your small business’s transactions will depend on the deal you are trying to get done. A letter of credit is a loan frequently employed by importers and exporters in international trade businesses, contractors, and travel agencies to serve as an assurance of payment. Some examples of transactions requiring a letter of credit include:

  • When an overseas customer places an order with a small business owner in the United States, a letter of credit documents the buyer’s obligation and guarantees that if the small business ships the requested product, it will be paid in full.
  • An equal housing lender working with a first-time buyer of commercial real estate or a home in another market may require a letter of credit from the buyer upon making a purchase offer to protect the seller.

Commercial letter of credit

A commercial letter of credit is one of the most common types of letters of credit issued by commercial lending institutions to entrepreneurs. This type of letter means that issuing lender will make the payment directly to the beneficiary, although the transaction will still record the borrower’s business name when funds are issued.

Standby letter of credit

Unlike the direct payment method of a commercial letter of credit, a standby credit letter uses a secondary payment method. The borrower pays the seller directly for the transaction and the lender only becomes involved in issuing funds if the borrower does not pay.

Revolving letter of credit

Letters of credit are typically for one specific transaction and expire within six months of credit approval, however, a revolving letter of credit means that the borrower can make several draws on the credit within the defined time period.

Pros and cons of getting a letter of credit

Weighing the pros and cons of decisions that affect the company’s bottom line is an important part of strategic business planning is weighing. Obtaining a letter of credit will affect your small business credit score and be reported to the three major credit bureaus just like business credit cards or a line of credit. If you default on the repayment terms of the purchasing agreement, it will decrease your business’s creditworthiness which can impact future lending options. So should you get a letter of credit? Here are some pros and cons:

Advantages of a letter of credit

A letter of credit can provide:

  • Security – If you are the seller in a transaction guaranteed by a letter of credit, then the most important advantage is that the security of knowing the buyer can pay their debt. If you’re the buyer, the transaction is more likely to go through providing a letter of credit.
  • Safety – Making large payments to international companies can be complicated and risky. As an individual, it is difficult to verify the credibility of the financial institutions receiving the funds. Using a letter of credit is safe for the seller because they can ship merchandise or remove the asset from the market with reassurance that the deal will close. For the buyer, there is safety in not having to wire funds from your business checking account until you’ve received the product.
  • Time savings – Large business transactions require a lot of paperwork. Along with paperwork comes several periods of waiting for confirmation from the parties involved, including a credit check for everyone involved. With a letter of credit, the banks handle approval requirements and all the funding paperwork. The transaction can be completed much faster than without a letter of credit.

Disadvantages of a letter of credit

While a letter of credit sounds like a must-have in any international deal, there are risks worth considering when using a letter of credit.

  • Time constraints – Bank guarantees provided in letters of credit, unless they specify “revolving,” are time sensitive and typically list an expiration date that is between 60 to 180 days past the date of approval. If there is a delay in the sale, the letter of credit may no longer guarantee payment.
  • Difficult to change – Changes in dates, amounts, or terms, to a letter of credit require a formal amendment with the issuing bank. Changes can take time and cost money.
  • Expensive – Just like with any other business lending service, there are financing costs to obtaining a letter of credit from a bank or lender. Typically, the buyer pays the fees which are based on the full amount of the transaction.
  • Liability – According to the member FDIC website, letters of credit are one of the “largest sources of credit risk for most institutions.” The issuing bank will weigh those risks, along with any risks presented in the credit history of the applicant when assigning fee rates.

How to get a letter of credit for your small business

Getting a letter of credit works like applying for a small business loan at a bank. The first step is to contact a bank or lender. Start with the bank or lender that you are already doing business with. Applying for a letter of credit at the same institution you have a business bank account or small business loans can save your company time and money because they already have access to your business’s credit history and banking information. Since the cost of the letter of credit is determined by the issuing lender, having a relationship with the bank may help you to negotiate a better rate.

The issuing bank will explain the credit application process to you, as they vary from lender to lender. The lender will also give you a list of required documentation, including the details about the transaction it will be used to guarantee, and any reports required to verify net worth and creditworthiness. If the applicant has the funds in their bank account, the issuing bank will either require that those funds are paid upfront, or it may issue a hold on the funds until they are ready to be released. Once the transaction is complete, the issuing bank will likely require a signature on a few more documents upon delivery of goods.

FAQs

Letters of credit are complex legal and financial documents for even the most seasoned small business owners. If you are contemplating the next right financial move in your business plan, we recommend reaching out to a financing expert at Biz2Credit for guidance.

I just opened a startup small business owner, but I could not get approved for a letter of credit. can I take out a loan to prepay my business obligations? Yes. If you are a new business owner, you may want to check out some of the loan programs backed by the U.S. Small Business Administration (SBA) or ask a lender about the eligibility requirements for a term loan.

Our small business is set up as a partnership and we are not willing to put up the collateral required for a revolving letter of credit. Is there a similar funding program that doesn’t require collateral?  Yes. Consider applying for an unsecured business line of credit, which will offer the same flexibility and access to fast funding as some credit letters.

Our business used a letter of credit last year when working with a contractor overseas, will we get approved for a letter of credit on a higher value in the future? A borrower’s approval requirements vary depending on the lender they are working with, and the current financial status of the business involved, so there is no way to say for sure that you’ll be able to get another letter of credit in the future.

Since the Federal Reserve has raised interest rates recently, do letters of credit get more expensive for borrowers? The fees for a letter of credit are based on the total guaranteed amount of the letter, at a percentage rate set by the lender. While the economy impacts all finance activity, it is unlikely that the letter of credit costs will be affected.

Bottom line

A letter of credit is a finance tool that guarantees payment on the behalf of the borrower, used primarily by individuals in the import/export industries and those conducting complex business deals. Letters of credit typically expire within six months of issuance, except for revolving letters of credit. Before applying for a letter of credit, consider the pros and cons of doing so. It may be a good idea to explore other options, like the line of credit from Biz2Credit this accounting firm used to cover operating expenses.

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