What Is a Letter of Credit?

4 min read • Jul 19, 2021 • Derek Miller

A letter of credit is a statement by a bank or financial institution on behalf of a customer. This is typically used in B2B transactions when one company wants to assure another that it will pay the full amount agreed to in the transaction. When your business receives a letter of credit, it comes with the promise that the bank will pay the balance owed in full, even if the customer cannot. 

A letter of credit can be used to move a sale forward. The letter recipient can rest assured knowing that they’ll receive payment, and the buyer can receive the goods they need to grow their business. 

Learn more about the process of issuing and receiving a letter of credit during a sale. 

Defining a Letter of Credit 

A letter of credit is defined as “a statement issued by a bank to the buyer of a good stating that the seller will receive payment on time and in the correct amount.” You might also see the term “irrevocable letter of credit” to describe this financial concept. 

Letters of credit are often used for major business transactions. When you’re purchasing thousands of dollars in goods, it helps to have the backing of a bank to prove that your vendor will get paid. If you don’t have the funds on hand to make the purchase, this letter can ensure that your vendor gets paid on time—given the net terms established in the contract. 

Because small businesses typically don’t have a lot of working capital around to cover materials or inventory, they usually purchase on credit—and a letter of credit from a bank can provide peace of mind to vendors that they’ll be paid in full.

These letters are more common with international trade. When companies work with customers in different countries, they’ll receive letters of credit from banks—often international firms that specialize in trade—proving that the companies they work with are good for the money.  

Who Issues a Letter of Credit?

The most common source for a letter of credit is a national or international bank. These companies are used to working with large businesses and enterprises that engage in large-scale trade. 

The letter of credit will often cover more than just the payment amount to the seller. It will also include important details that are relevant to the exchange of goods. For example, it will include when the business will receive payment (before the delivery of goods, after, or half-and-half) and when the seller will deliver the goods to the buyer. These terms were likely already discussed by the two companies involved, but the bank will work to confirm the details. 

Like any other loan, there is a process to issuing letters of credit. The bank will conduct background checks on the buying company, check the credit of the business, and possibly ask for deposits as a way to hold the company accountable. These steps all reduce the risk levels of issuing a letter of credit and increase the chances of repayment. 

While it can take time to issue a letter of credit, it still allows buyers to get the goods they need faster so they can continue operating their businesses.   

What Is the Cost of an Irrevocable Letter of Credit?

Banks agree to issue irrevocable letters of credit because they profit directly from funding the transaction. This is no different from a bank issuing a loan or mortgage: they’re happy to provide the money because they benefit from the interest you pay on the loan. 

The standard cost of a letter of credit is around 0.75% of the total purchase cost. For letters that are in the 6 figures (typically around $250,000), these fees can add up and benefit the bank. In some cases, the letter of credit commission could fall close to 1.5%. 

The buyer typically picks up the costs associated with the letter of credit. However, the seller may receive some charges as well. These include charges related to wire transfer costs, courier fees, and bank fees. By the time the transfer is complete, the seller can expect to pay between 5 to 10 fees—most ranging from $25–$150. 

On top of the fees, the buyer will typically need to put down a deposit on the letter of credit. This is usually around 1%. A deposit proves that the buyer is serious about repaying the rest of the money to the bank.   

Know Your Funding Options

Letters of credit aren’t limited to international trade deals worth hundreds of thousands. You may be able to use this option as a way to buy materials and close deals with local vendors. If you need cash to complete business purchases, talk to your local bank—they can walk you through the letter of credit process. 

Alternatively, you can look for short term loans and other funding choices to increase the capital of your business. Explore the online loan center at Lendio to find financial institutions that want to help you. Use our services to grow your business. 

Derek Miller

Derek Miller is a writer specializing in entrepreneurship, small business, and digital marketing. His work has featured in sites like Entrepreneur, GoDaddy, Score.org, and StartupCamp. He’s currently the CMO of Smack Apparel, the content guru at Great.com, and a marketing consultant for small businesses.