A letter of credit is basically a letter from the bank officials which guarantees that a buyer’s payment to the seller will be received on time and for the right amount. In case the buyer is not able to make payment for the purchase, the bank has to cover the full or the remaining amount of the purchase the buyer has made. Due to the increasing demand for international dealings, the primary factors such as distance, difference in laws, and difficulty in knowing the parties concerned personally, these letters of credit have become a very influential aspect. This letter of credit is generally issued against a pledge of securities and cash. Banks collect a certain amount for performing this procedure.
How does the Letter of Credit work?
Since the letter of credit is a negotiable tool, the bank issuing it will pay the beneficiary or any other bank which is nominated by the beneficiary. If the letter of credit has to be transferred, the beneficiary can assign another entity like corporate or a third party, the right to draw. Hence, letter of credit makes it possible to do business to any corner of the world. The concerned parties required for this procedure are the applicant, the issuing bank, and the beneficiary.
There are various types of letter of credit.
- Sight credit: According to this letter of credit, documents are said to be payable at the sight or presentation of the proper documentation along with the proofs. For instance, a businessman can show the bill of exchange to a lender which is attached to a sight letter of credit and receive the required amount of funds right away. This is the fastest forms of letters of credit available.
- Acceptance credit or Time credit: The bills of exchange which are drawn and payable after a certain amount of time are known as usance bills. Under this type of credit, the usance bills are approved upon providing the necessary presentations and proofs. These usance bills are eventually honored on their respective due dates. For instance, when an organization purchases some of the materials from a supplier and gets the supplies the very same day, the bill will be delivered with the shipment. The organization will have 30 days to pay for it. This period of time marks the usance for the sale.
- Revocable and Irrevocable credit: A revocable letter of credit is a credit under which the terms and conditions can be either edited or canceled by the issuing bank. The issuing bank will have the freedom to cancel the letter of credit without prior notice to the beneficiaries as well.
An irrevocable credit, on the other hand, is a type of credit where the terms and conditions can neither be amended nor canceled. In this way, the opening bank is bound to be committed to all the terms according to the letter of credit.
- Confirmed credit: A confirmed letter of credit is a type of credit where the banker apart from the issuing bank adds their own confirmation to the credit. In such letters of credit, the beneficiary‘s bank will have to submit all the required documents to the confirming banker.
- Transferrable credit: A letter of credit is generally not a negotiable instrument. However, the bills of exchange which can be drawn under it are negotiable. A transferrable credit is one where a beneficiary can transfer his or her rights to third parties. These kinds of letters of credits are thus known as transferrable letters of credit.
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