What it means
A letter of credit sits between two companies that do not know each other well enough to trade on trust. The seller does not want to ship before being paid, the buyer does not want to pay before the goods exist, and the bank breaks the deadlock by promising to pay against paperwork.
The instrument is documentary, meaning the bank checks documents rather than goods. If the bill of lading, commercial invoice and inspection certificate match the terms written into the credit, the bank pays; if a detail is out of place, it can refuse until the discrepancy is corrected or waived.
For a finance team, a letter of credit is mostly a cash flow and cost question. The issuing bank normally reduces the buyer's available borrowing by the face value of the credit, so a $2,000,000 letter of credit ties up $2,000,000 of headroom even though no cash has left the account.
Several variants are worth recognising. A confirmed letter of credit adds a second bank's guarantee, which helps when the seller is wary of the issuing bank's country, and a standby letter of credit behaves more like a guarantee that is only drawn if the buyer fails to pay directly.
The important nuance is that a letter of credit protects payment, not quality. Banks pay against compliant documents even if the shipment turns up damaged or short, so buyers still need inspection clauses and contractual remedies alongside the credit.
In practice
Real-world examples
Example 1
A furniture retailer places a $600,000 order with a new manufacturer overseas and the supplier refuses open credit terms. The retailer's bank issues a letter of credit payable on presentation of shipping documents, so the supplier begins production knowing payment is assured. The retailer pays roughly $3,000 in fees rather than wiring $600,000 in advance to a company it has never dealt with.
Example 2
A construction contractor must show a client it can meet warranty obligations after a project completes. Instead of leaving $400,000 of retention cash locked up for two years, it provides a standby letter of credit for the same amount, which the client can draw only if defects go unremedied. The contractor keeps the cash working in the business and pays an annual fee instead.
Example 3
A commodity trader buying grain in a market with volatile banking conditions asks for its letter of credit to be confirmed by a large international bank. The confirmation adds around 0.5% a year to the cost but means the seller looks to a familiar institution for payment. The deal closes at a price the trader could not have secured on documentary collection terms alone.
Think of it
Imagine selling your bicycle to a stranger online. Instead of handing over the bike for a promise, you both leave the cash and the bike with a trusted mutual friend. Once the friend sees the bike is handed over safely, they give the cash to you.
Formula
Calculation
Letter of credit cost = (face value x annual fee rate x days outstanding / 360) + fixed issuance and amendment charges
An importer arranges a $2,000,000 letter of credit to cover a machinery shipment from an overseas supplier. Its bank charges 1.5% a year on the face value plus a flat $500 issuance fee, and the credit stays open for 90 days from issue to payment. The annual charge would be $2,000,000 x 1.5% = $30,000, so 90 days of cover costs $30,000 x 90 / 360 = $7,500. Adding the $500 issuance fee gives a total of $8,000, which is $8,000 / $2,000,000 = 0.4% of the shipment value, a price the importer judged reasonable against the risk of prepaying a supplier it had never used.Case study
Seen in the real world
Harbourline Spice Co is an illustrative importer created to show letters of credit at work. It wanted to buy $2,000,000 of cardamom from a supplier it had met only at a trade fair, and the supplier insisted on full prepayment. Neither side would move, and the season was closing.
The finance manager proposed a letter of credit payable 30 days after presentation of a clean bill of lading, a certificate of origin and an independent quality certificate from a named inspection firm. That last document was the point of the whole exercise, because it meant the bank would not release payment on a shipment the inspector had rejected.
In this fictional example the total banking cost came to about $8,000 against a $2,000,000 order. Harbourline avoided sending money abroad on trust, the supplier got a bankable promise it could show its own lender, and both sides had a written definition of what "shipped correctly" actually meant.
Watch out
Common mistakes
- Believing a letter of credit guarantees the goods are satisfactory. Banks deal only in documents, so quality protection has to come from inspection certificates and the underlying sales contract.
- Ignoring the effect on borrowing capacity. Most banks block an equivalent amount of the customer's facility while the credit is open, which can quietly starve the business of working capital.
- Drafting terms that are impossible to satisfy, such as demanding a document the shipping line will not issue. Unrealistic conditions cause discrepancies, delayed payment and an irritated supplier.
Questions
People also ask
How long does a letter of credit stay open?
It runs to a stated expiry date, commonly 30 to 180 days, and it lapses if the seller has not presented conforming documents by then.
Who pays the fees?
The buyer usually pays the issuing bank's charges and the seller pays its own bank's advising or negotiating fees, but the split is negotiable and should be written into the contract.
Is a standby letter of credit the same as a bank guarantee?
They serve a very similar purpose as a backstop if someone defaults, though they follow different rule sets and wording conventions depending on the market.