What is a Letter of Credit, and How Can it Help You?

From debit cards/ credit cards to UPI, we live in an era that supports ‘n’ number of payment modes. It has become not only easy for the customers to make payments but also for the sellers who have to make payments to the intermediaries and other parties involved in the business.

In between the plethora of payment options, there is a letter of credit. But the question that you might stumble upon is, is it even relevant when you have lots of other payment alternatives to choose between? It is. A letter of credit might not be the most popular way of making payments, but it sure shot is a reliable and convenient one if it meets your preferences and requirements.

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Thus, we will be discussing a letter of credit in detail, state the advantages and then leave it for you to decide if it’s the right payment option for you.

What is a Letter of Credit?

A letter of credit is a payment document issued by the bank that assures and guarantees the payment that is to be made by the buyer to the sellers. A buyer is the one who purchases a line of credit from the bank, and the seller is the one to whom the payment is to be made. The buyer here can be someone who has to make payment to you (can be your customer), and the seller can be the receiver (you).

So, even if the buyer doesn’t make the payment, the bank pays the seller on their behalf. In alternate words, it is a promise of payment that a buyer makes to the seller.

Bank letters of credit are generally used for international transactions. This mode of payment is opted for because of the variation of laws in countries, and challenges concerning knowing the party personally increase the hazards businesses can face, making use of bank letters credit safe and convenient.

Who Should Choose a Letter of Credit and Why

A letter of credit is ideal for businesses that make and accept recurring payments in a risky transactional environment wherein the payment is not guaranteed or at risk. It is also ideal for those who are looking to make international transactions.

Importance of Letter of Credit

A letter of credit can be significant when it comes to ensuring that the buyer will only make payment when the seller has authentic proof that the products purchased have been shipped. The buyer is not required to make any advanced payments that might be unnecessary. The letter of credit can also be chosen to show that your business is all set to engage in trade with companies outside the country.

In addition, a letter of credit can also act as an assurance given to the seller that they will receive the payment even when the buyer fails to pay them. It can also serve as a legal document to safeguard the seller from any legal risks as long as the terms & conditions are fulfilled.

Other than international trade, bank letters of creditcan also support businesses in accumulating funds for their crucial projects. It can also help verify the credit status of a party. If the buyer is unable to pay for the purchases, the bank or financial institution will shoulder them.

Advantages of Using a Letter of Credit

Using bank letters of credit has the following advantages:

  • It enables trading partners to deal with new and unknown parties that are risky – mostly international clients. It can also help the business expand and stretch to new geographical boundaries. Thus, a letter of credit can act as a safety net for businesses that have been skeptical about taking up foreign projects.
  • It can provide a safe exit for the seller in case the buyer makes any default on the payment or goes bankrupt. With a letter of credit, the buyer’s creditworthiness is shifted to the bank, which means it must pay the promised amount.
  • Both trading parties have the privilege to add terms and conditions as per their requirements and settle on a mutual arrangement regarding the purchase. Customization is also possible between transactions within the same parties.
  • If there happens to be a dispute between the parties, a letter of credit can allow the seller to withdraw funds first and later resolve the conflict.

How to Get a Letter of Credit?

To avail of bank letters of credit, a buyer needs to approach a bank of their choice for the issue. It’s recommended that you refrain from picking a new bank but the one that you have a previous banking relationship with.

The letter of credit bank guarantee procedure requires them to provide full documentation of the agreement in question, as well as the bank’s required application forms for internal processing.

The process of acquiring a letter of credit requires the buying party to provide full documentation of the concerned agreement. You must also fill out the required application form as a part of the letter of credit bank guarantee procedure.

The Bottom Line:

Bank letters of credit are a useful mode of payment for MSMEs. It can provide transaction safety and certainty that can smoothen your operations by ensuring a smooth flow of funds to carry out your business operations.

So, if the shoe fits right, feel free to wear it. You can connect with HDFC, one of the leading banks in India, to avail a letter of credit to make seamless and secure transactions both locally and internationally.