What is a letter of credit in simple words: essence and meaning

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

What is a letter of credit in simple terms? This question can be found quite often on the World Wide Web. Many people believe that this word is used to refer to some complex term that is incomprehensible to the average person, but in reality everything is simpler than it seems. In our article today, we will tell you in detail what a letter of credit in a bank is. Interested? Then start familiarizing yourself soon!

What is a letter of credit in simple terms?

We will not beat around the bush, but will immediately give an answer to your question. In the simplest terms, a letter of credit is one of the best and most reliable ways to protect your organization from the risks associated with prepayment for financial transactions. A letter of credit provides an opportunity to insure when cooperating with new partners. The bank in this situation is an intermediary, whicha special account temporarily stores money. He also acts as a kind of guarantor, who takes responsibility for the payment of finances. This creates favorable conditions for both the supplier and the recipient.

Letter of credit - a special bank account that gives the right to reserve the finances on it in trade relations. If both parties comply with the terms of the agreement, the bank must pay a certain amount of money to the recipient.

Where is the letter of credit used?

A letter of credit in a bank in simple words - what is it? We think this question is clear. Now let's find out where it is used. As a rule, these forms of calculation are most often used in the business sector: an entrepreneur who ordered a product can be sure that finances will be withdrawn from his working account only after shipment. The supplier, in turn, can be sure that he will receive his well-deserved monetary payment. Funds are transferred only when the bank receives the necessary documents. In addition, the letter of credit form of payment is often used when concluding large purchase-sale transactions.

How does a letter of credit work?

In order to answer this question, you just need to familiarize yourself with the algorithm of actions of the parties who decided to use the form of calculation we are discussing:

1. The supplier declares the opening of a letter of credit in writing, after which a bank account is assigned to him.
2. After receiving the goods, the buyer submits documents to the bank,which confirm the fulfillment of the terms of the contract with the supplier.
3. When the above procedures are done, the pre-agreed amount of money is withdrawn from the buyer's account.

Withdrawals can be made by either the paying bank or the receiving bank.

Letter of credit agreement

In addition to what a letter of credit is in simple terms, you also need to know what is needed to complete the transaction.

The document that regulates the relationship of the parties contains all the information necessary to complete the transaction. The contract fixes:

• Type of form used.
• Commission fee.
• Details of participants.
• Bookable finance amount.
• Instructions needed in case of default.
• Terms of the letter of credit.
• Payout order.
• Rights and obligations of both parties.

Types of letters of credit

There are the following types of letters of credit in the bank:

Coated (deposited)	Most used. Funds are transferred from the very beginning to the account of the beneficiary bank
Uncovered	The executing bank is given the right to withhold finance from the correspondent account within the amount specified in the agreement
Revocable	The issuer may cancel the transfer of funds if the payer makes a written order. Consent from the recipient is not required
Irrevocable	Agreementcanceled only when the seller agrees to this
Confirmed (Revocable/Irrevocable)	Payments are made by the contractor even if there are no funds on the payer's account
Reserve	The bank that opened the account can provide a written undertaking to the seller about the history of payments in the event that the buyer does not comply with the terms of the contract. In such a situation, the buyer will fulfill all obligations to the supplier
Revolver	As a rule, they open for a part of the full amount of the payment, and after the accrual of funds from the buyer, it resumes to the previously specified amount. Used in areas where goods are delivered on a specific schedule
Circular	Gives the right to receive funds under a letter of credit in all correspondents of the advising credit institution
With red clause	At the direction of the issuer, the advising banking organization credits the finance to the seller before he provides documents confirming the delivery

Now let's take a closer look at the most requested.

Covered and uncovered

Deposit and guaranteed transactions are the most commonly used letters of credit. Types of contracts determine the specification of the operations themselves.

1. Covered operation. In this case, when issuing a letter of credit, the issuing bank transfers funds through the payer's account for the entirethe size of the letter of credit. Finances are given to the full disposal of the executing bank for the entire duration of the transaction.
2. Uncovered transaction. A guaranteed banking operation involves the transfer of funds by the issuing bank. The executing credit institution is given the opportunity to withdraw finance from its account within the value of the letter of credit. The procedure for withdrawing money from an account in the issuing bank is determined by special agreements between financial institutions.

Revocable and irrevocable

In second place in demand are revocable and irrevocable. They also have their own special features.

1. Revocable operation. The issuing bank has the full right to modernize or completely cancel the revocable banking operation. The basis for the withdrawal of a letter of credit may be a written order from the payer. Coordination with the recipient of the amount of money in this case is not required. After this procedure, the issuing bank does not bear any responsibility to the payer.
2. Irrevocable operation. A non-repudiable letter of credit can only be canceled if the recipient agrees to change the terms of the contract. Partial change of conditions in this situation is not considered.

The recipient of funds from a banking transaction may refuse to pay, but until the expiration of its term and provided that this was stipulated in the agreement. By prior arrangement, the acceptance of a third party who has the rights of the payer is also allowed.

Pros and cons

In addition to what a letter of credit is in simple words, many are also interested in the advantages and disadvantages of this phenomenon.

Unambiguous pluses include:

• Legal control of the contract.
• Possibility of receiving excess profit from the buyer's account.
• Reducing the risk of not receiving the amount that was agreed upon in the agreement.
• Assurance for the buyer to receive delivery on time.
• The right to save on interest payments (which cannot be done with a regular loan).

If we consider letters of credit objectively, we should also talk about their disadvantages:

• Duration of the contract due to the large number of documents.
• Possibility of limiting the transaction by the state.
• Expensive commission.
• Funds are not credited to the beneficiary's account without providing the documents specified when drawing up the contract.

Mutual settlements

When concluding a contract in the contract, it is necessary to indicate the form of mutual settlements, as well as the scheme for the provision of services or features of the delivery of goods. In addition, the planned types of letters of credit and their features are prescribed in the papers. To avoid problems in the future, the following information should be in the contract:

• Name of the issuing bank.
• Identification data of the recipient of finance.
• Name of the financial institution that serves the recipient of the money.
• The amount of money in the bankoperations.
• Types that both sides are going to use.
• Method of informing the recipient of funds about the opening of a transaction in the bank.
• Method of informing the payer required to deposit money.
• The term of the letter of credit, the timing of the provision of important papers and the rules for their execution.
• Features of transaction payment.

Letter of credit operations

Services for letter of credit transactions can be implemented in different ways, it all depends on the credit institution. As a rule, banks carry out such operations:

1. Opening a service. The bank opens a financial liability after the client's application. To make this obligation a reality, the bank, on behalf of the applicant, must transfer the amount of money in favor of the seller of goods or real estate. On top of that, the issuer can entrust the execution of this obligation to another bank after checking all important securities.
2. Confirmation of commitment. The bank issues a guarantee of payment for a letter of credit, which was drawn up by another banking organization.
3. Advising a letter of credit. Notification to the credit institution that the letter of credit has been opened, modified or closed. Official notice is usually sent by letter, fax or any other electronic means of communication. After checking the papers, the bank informs the seller about the issuance of an invoice for the amount specified in the contract. Advising is controlled by the norms of the law, therefore, in order to avoid violations, banks devote a lot of time and effort to this process.
4. Fulfillment of an obligation. The first stage consists ofverification of the submitted papers from the recipient of finance. When two banks are involved in a transaction, the executing party must advise the issuing bank of payment. This procedure is acceptable only if the documents comply with the terms of the contract. If the documents do not meet these conditions, then the obligation is not fulfilled. Payment becomes possible when the buyer agrees to accept documents with defects.

What should I pay attention to?

What is a letter of credit in simple terms, we have already discussed. In the end, we will focus on a few important points.

In order for the partnership to be successful, the payer must, on his own or with the help of a professional, study this format of banking operations. Letters of credit differ depending on the form of mutual settlements. For a certain case, you need to choose the optimal form of partnership.

Kcredit is in simple words what? We hope we managed to give a clear and understandable answer to this question!