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What is a Letter of Credit and Why is it Important?

If you have a business with an international reach, you may be hesitant to deal with a new buyer, especially if the buyer is from another country. Do not worry, though; there are many options that you can use to assure you of having a successful transaction. One of these options is to ask for a letter of credit.

What is a Letter of Credit?

A letter of credit is a note coming from a bank that guarantees a buyer’s payment to a seller once the seller fulfills the delivery of the products or goods being sold. If the buyer fails to make payments, the bank that issued the letter of credit will be required to cover the full cost of the purchase. A letter of credit offers protection to both the seller and the buyer.

Protection for the Seller. A letter of credit protects the seller from bogus buyers. Once the buyer fails to make the full payment, the bank that issued the credit letter will have to pay the seller the full amount of the transaction provided that the seller has fulfilled all the requirements of the letter.

Protection for the Buyer. Letters of credit also protect the buyers. If you are a buyer and already paid partially for a product that has not yet been delivered, a letter of credit will ensure that you will get a refund for the amount you already paid. Likewise, a letter of credit may also penalize a seller for not fulfilling the delivery. You can use the money you receive to pay another seller.

Where Does the Money Behind a Letter of Credit Come From?


The bank that issues a letter of credit acts a disinterested third party and releases the letter’s amount after both the seller and the buyer has fulfilled all the requirements. The money behind the letter of credit will come from the buyer. A bank may require the buyer to pay upfront the amount of the products. Likewise, the bank may freeze the buyer’s funds held at the bank. The bank may also provide a line of credit for the buyer in exchange for collateral.

Letters of Credit protects both the buyer and the seller

Why are Letters of Credit Important?

Letters of credit are instruments that reduce the risk of fraudulent transactions. They serve as a means of protection for both the buyer and the seller. Likewise, letters of credit are not only limited to the buying and selling of goods. You may also use credit letters for performance transactions such as hiring a contractor to work on a building.

With performance transactions, the services buyer must show proof that the service provider failed to do something. For example, a homeowner hires a contractor to remodel his home, and a letter of credit is made to protect the homeowner and the contractor. If the contractor finishes his work as agreed in their contract, the bank will release the contractor’s funds as payment. However, if the contractor failed to finish the work, the bank will refund the homeowner’s funds to hire another contractor to finish the work.


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