Letter of credit explained
What a letter of credit is
A letter of credit is a formal promise from a bank, working on behalf of a buyer, to pay a seller once the seller submits documents that fit the credit's requirements. In cross-border trade, this gives the exporter a way to count on a bank instead of trusting a buyer they may never have met. You’ll most often see the documentary letter of credit, which operates based on paperwork like the bill of lading or the commercial invoice. Or, you could use a documentary collection, which costs less because the banks handle paperwork but don’t promise to pay; this makes it less reliable.
The banking procedures come from the International Chamber of Commerce and its Uniform Customs and Practice for Documentary Credits (UCP 600), a rulebook followed by most banks. Under this system, the bank reviews paperwork only, it never inspects the goods themselves. So document accuracy is key.
The steps in a typical letter of credit
- The buyer and seller settle the deal, then write in the contract that payment will use a letter of credit.
- The buyer’s bank (the issuing bank) issues the credit naming the seller as beneficiary.
- The advising bank, located in the seller’s country, lets the seller know the letter exists. Sometimes, a confirming bank also backs the credit with its own promise of payment.
- The seller ships the goods and provides the set of documents required (this usually means the commercial invoice plus a transport document like the bill of lading) to their bank.
- The bank checks these documents against the credit. Where everything matches, the bank pays the seller. After that, the issuing bank reimburses the advising or confirming bank, and the buyer pays the issuing bank.
Costs and discrepancies that delay payment
A letter of credit can cost more than other options, because several banks will process and review the paperwork, and each may charge fees for issuing, advising, confirming, amending or paying. Charges differ by bank and from deal to deal, so request a detailed fee schedule before you proceed. To put letters of credit into perspective, you can check the trade payment methods.
Most delays come from discrepancies. That means anything in the supplied documents that disagrees with the letter of credit. It could be as small as a mismatched name, a slightly different description of the items shipped, missing a deadline, or submitting documents after expiry. If, for example, the transport document (the bill of lading) says something a little different from the invoice, the bank may refuse to pay until the issue is fixed or the buyer gives written acceptance of the change.
Frequently asked questions
Is a letter of credit a guaranteed payment?
No, it is a bank’s promise to pay if, and only if, the paperwork meets every term and deadline in the credit. That’s strong security, but not an absolute guarantee. Payment depends on documents, not whether the shipment actually happened as described. If there’s a confirming bank, its promise stands alongside the issuing bank’s. If unconfirmed, you’re relying on the issuing bank alone.
Who pays the fees on a letter of credit?
Fee sharing depends on what buyer and seller agree in the contract. Commonly, the buyer pays the issuing bank's charges, and the seller covers the advising bank (and any confirming bank) fees. Always look at the written contract settlement, and ask each bank for its costs before starting. If a seller needs money sooner, before the buyer has paid, there’s also export factoring, though that’s a different service entirely.