Introduction
Letter of credit is a payment method used in international trade to ensure that payment is made through a letter of credit obtained from a bank. A letter of credit is a letter of guarantee issued by a bank on behalf of an exporter in favor of a foreign importer. The exporter can obtain a letter of credit from their bank, which can be used to pay for the goods they are exporting. The letter of credit is a guarantee from the exporters bank that the exporter will receive payment from the importers bank upon fulfilling the terms and conditions outlined in the contract.
The exporter is responsible for obtaining a letter of credit from the importers bank. This document will provide the importer with the assurance that the payment for the goods and services that have been sold will be received upon completion of the transaction. The exporter will then send the letter of credit to the importers bank and the importers bank will then issue the payment to the exporter.
Types of Letter of Credit
The two types of letters of credit are a confirmed letter of credit and an unconfirmed letter of credit. A confirmed letter of credit is one which is guaranteed by an additional bank, in addition to the bank issuing the letter of credit. This additional bank provides the importers bank with additional assurance that the funds will be paid, should the exporter fail to fulfill their obligation.
An unconfirmed letter of credit is one which is not guaranteed by an additional bank and does not provide the additional assurance that payment will be made upon completion of the deal.
Advantages of Letters of Credit
One of the key advantages of a letter of credit is that it is an obligation of the importer to pay the seller, instead of the seller relying on the payment from the importer. With the use of a letter of credit, the seller is assured that their payment, amounting to what their goods are worth, is guaranteed by the bank, making it a very safe and secure method of payment.
Another advantage of letters of credit is that it places the responsibility and liability on the importer’s bank and not on the seller. This is because the agreement is between the importers bank and the exporters bank and not between the buyer and the seller. This protects the exporter from the potential of receiving a payment from the buyer which is lower than the agreed upon contract price.
Disadvantages of Letters of Credit
One of the main disadvantages of letters of credit is that it can be costly to obtain. The process of obtaining a letter of credit requires a lot of paperwork and time to complete. Banks also charge fees for issuing letters of credit, both to the exporters and importers, so it can be an expensive way for payment to be made.
Conclusion
Letters of credit are a reliable and secure way for payments to be made in international trade. They provide assurance to both the importer and exporter that payment can be made without the risk of not receiving the payment. Despite their benefits, letters of credit can be costly to obtain and take a considerable amount of time and paperwork to process. Nevertheless, they are often preferred among those trading items of high value, allowing the importer to obtain the guarantee of payment before shipment, and the exporter to receive payment after shipment.
