Commercial Letter of Credit: How It Works and Costs

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A Commercial Letter of Credit is a document issued by a bank that guarantees payment to a seller if the buyer's terms are met. It's a crucial tool for international trade, but how does it work and what are the costs involved?

The buyer opens a letter of credit with their bank, which then issues a letter of credit to the seller. This letter outlines the terms of the sale, including the amount, payment method, and delivery requirements. The seller must then present the documents specified in the letter of credit to the buyer's bank to receive payment.

The cost of a commercial letter of credit varies depending on the bank and the type of letter of credit. According to the article, the cost can range from 0.5% to 1% of the letter of credit amount.

What Is a Commercial Letter of Credit?

A commercial letter of credit is a type of letter of credit that's commonly used for one-off transactions.

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It's also known as an import/export letter of credit or a documentary credit (DC). This type of letter of credit involves a bank acting as a neutral third party.

The bank makes direct payment to the beneficiary when all contractual agreements have been met. This ensures that the buyer and seller fulfill their obligations.

Commercial letters of credit are frequently used for transactions that involve a single payment, rather than ongoing or recurring payments.

Types of Commercial Letters of Credit

Commercial letters of credit are incredibly versatile, and understanding the different types can help you navigate complex international transactions with ease.

One of the most common types of commercial letters of credit is the sight letter of credit, which allows the beneficiary to be paid immediately upon presentation of specified documents.

A confirmed letter of credit is another type, where a confirming bank adds its undertaking in addition to that of the issuing bank to honour a complying presentation.

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The revolving letter of credit is perfect for frequent merchandise shipments, as it allows customers to make any number of draws within a certain limit during a specific period.

A confirmed letter of credit is an irrevocable undertaking issued by another bank/entity, making it a reliable option for international transactions.

Here are some of the most common types of commercial letters of credit:

  • Sight Letter of Credit: Paid immediately upon presentation of specified documents
  • Confirmed Letter of Credit: Issued by another bank/entity, adding its undertaking to honour a complying presentation
  • Revolving Letter of Credit: Allows customers to make any number of draws within a certain limit during a specific period
  • Transferable Letter of Credit: Allows the seller to transfer the credit either fully or partially to one or more parties
  • Back-to-Back Letter of Credit: Involves two letters of credit to secure financing for a single transaction

Parties Involved

A commercial letter of credit typically involves a bank serving as a neutral third party, making direct payment to the beneficiary when all contractual agreements have been met.

The applicant, who is the buyer, requests that their bank issues a letter of credit. This is a common practice for one-off transactions.

In a letter of credit transaction, there are several parties involved. Understanding who is who throughout this process can help you better navigate the process and the roles and responsibilities of each party.

Here's a breakdown of the key parties involved:

The issuing bank ensures the beneficiary will be paid once the conditions of the letter of credit have been met.

Commercial Letter of Credit Process

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A commercial letter of credit is a type of letter of credit that involves a bank serving as a neutral third party and making direct payment to the beneficiary when all contractual agreements have been met.

This type of letter of credit is frequently used for one-off transactions.

To apply for a commercial letter of credit, the importer's bank credit must satisfy the exporter and their bank.

The exporter and importer complete a sales agreement, which is then used to draft the letter of credit.

The importer's bank drafts the letter of credit, sends it to the exporter's bank, and the exporter's bank reviews it before sending it to the exporter.

The exporter ships the goods as described in the letter of credit and submits any required documentation to the exporter's bank.

The exporter's bank reviews the documentation to ensure the letter of credit terms and conditions were met.

If approved, the exporter's bank submits the documents to the importer's bank, and the importer's bank sends payment to the exporter's bank.

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Here is a step-by-step overview of the commercial letter of credit process:

  1. The importer's bank drafts the letter of credit.
  2. The exporter's bank reviews the letter of credit and sends it to the exporter.
  3. The exporter ships the goods as described in the letter of credit.
  4. The exporter's bank reviews the documentation to ensure the letter of credit terms and conditions were met.
  5. The exporter's bank submits the documents to the importer's bank, and the importer's bank sends payment to the exporter's bank.

Commercial Letter of Credit Benefits and Drawbacks

A commercial letter of credit is a useful tool for mitigating risk in business transactions where the parties may not have worked with each other previously or do not operate under common regulations and customs.

Letters of credit have several benefits for importers, including helping to seal the deal by demonstrating that the buyer is serious and has the capacity to pay, ensuring that buyers won't have to pay for goods until they receive confirmation of shipment, and enabling buyers to maximize working capital by eliminating the need for advance deposits.

For exporters, letters of credit safeguard against the possibility that exporters won't get paid once the goods are shipped, and can be used as collateral to secure short-term loans.

Letters of credit can also offer security and cash flow benefits to both the buyer and seller, and streamline the payment process in challenging trade environments.

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However, letters of credit do have certain limitations, including placing transactional costs disproportionately on the buyer's side, being a complex and time-consuming process for all involved parties, and leaving key aspects of transactions (like speed and quality) uncovered.

Here are some of the key advantages and disadvantages of letters of credit:

  • Can create security and build mutual trust for buyers and sellers in trade transactions.
  • Makes it easier to define the specifics of when and how transactions are to be completed between involved parties.
  • Letters of credit can be personalized with terms that are tailored to the circumstances of each transaction.
  • Can make the transfer of funds more efficient and streamlined.
  • Buyers typically bear the costs of obtaining a letter of credit.
  • Letters of credit may not cover every detail of the transaction, potentially leaving room for error.
  • Establishing a letter of credit may be tedious or time-consuming for all parties involved.
  • The terms of a letter of credit may not account for unexpected changes in the political or economic landscape.

Advantages and Disadvantages

Letters of credit offer security and cash flow benefits to both buyers and sellers. They can help mitigate risk in business transactions where parties may not have worked together before.

Commercial letters of credit are frequently used for one-off transactions. This type of letter of credit involves a bank serving as a neutral third party and making direct payment to the beneficiary when all contractual agreements have been met.

Letters of credit can create security and build mutual trust for buyers and sellers in trade transactions. They make it easier to define the specifics of when and how transactions are to be completed between involved parties.

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However, establishing a letter of credit may be tedious or time-consuming for all parties involved. This can be a drawback for businesses looking for a quick and easy solution.

Here are some key advantages and disadvantages of letters of credit:

Letters of credit can be useful tools for facilitating global commerce, but it's essential to consider both the benefits and drawbacks before deciding whether to use one.

Differences Between Trade Credit

Trade credit insurance offers businesses protection against the risk of non-payment due to customer insolvency or credit-related defaults.

Letters of credit typically provide coverage for a single transaction, whereas trade credit insurance can cover a variety of transactions with a given customer over time.

There are multiple parties involved in a letter of credit, including an applicant/buyer, beneficiary/seller, and various banks.

Commercial Letter of Credit Costs and Payment

A letter of credit is like an escrow account, where payment to the beneficiary only happens when the other party performs a specific act or meets other performance criteria spelled out in the letter of credit agreement.

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The cost of a letter of credit can vary by bank and the size of the letter of credit. Banks usually charge a fee, which can be a percentage of the total credit they are backing, ranging from 0.75% of the amount they're guaranteeing.

Fees can also depend on the type of letter. In an import-export situation, an unconfirmed letter of credit is less costly, while a confirmed letter of credit may have higher fees attached based on the issuing bank's credit strength.

How Much Costs

Commercial Letter of Credit Costs can add up quickly, but understanding what you're paying for can help you make informed decisions.

Banks usually charge a fee for a letter of credit, which can be a percentage of the total credit they're backing.

The cost of a letter of credit will vary by bank and the size of the letter of credit, with some banks charging 0.75% of the amount they're guaranteeing.

In an import-export situation, an unconfirmed letter of credit is less costly than a confirmed letter of credit, which may have higher fees attached based on the issuing bank's credit strength.

When Payment Occurs

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Payment with a commercial letter of credit only occurs when the seller meets all contractual agreements. This is similar to an escrow account, where payment is held until specific conditions are met.

A commercial letter of credit makes direct payment to the beneficiary when all contractual agreements have been met. This can be a significant advantage for buyers, as it ensures that payment is only made when the goods or services have been delivered and meet the agreed-upon specifications.

Payment can be made directly to the beneficiary, eliminating the need for the buyer to provide payment. This can be a cost-effective option for buyers, especially for one-off transactions.

The payment process with a commercial letter of credit is straightforward: payment is made when the seller performs a specific act or meets the performance criteria outlined in the letter of credit agreement. This provides a secure and reliable way for buyers and sellers to conduct transactions.

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Here's a summary of the payment process with a commercial letter of credit:

Payment with a commercial letter of credit is a secure and reliable way to conduct transactions, especially for one-off transactions.

Frequently Asked Questions

What is the difference between standby LC and commercial LC?

A Standby Letter of Credit (SLC) is a guarantee, not a transactional tool, while a commercial Letter of Credit is used for specific transactions. Key differences lie in their purpose and usage, with SLCs serving as a safety net and commercial LCs facilitating deals.

Sean Dooley

Lead Writer

Sean Dooley is a seasoned writer with a passion for crafting engaging content. With a strong background in research and analysis, Sean has developed a keen eye for detail and a talent for distilling complex information into clear, concise language. Sean's portfolio includes a wide range of articles on topics such as accounting services, where he has demonstrated a deep understanding of financial concepts and a ability to communicate them effectively to diverse audiences.

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