What is a Letter of Credit, What are the Types?

What is a Letter of Credit?

A Letter of Credit is a contractual commitment by the foreign buyer’s bank to pay once the exporter ships the goods and presents the required documentation to the exporter’s bank as proof.

As a trade finance tool, Letters of Credit are designed to protect both exporters and importers. They can help you win business with new clients in foreign markets. This means the exporter gets a guarantee of payment while offering the importer reasonable payment terms.

Before Applying for a Letter of Credit

Letters of Credit are one of the most secure payment instruments available but can be labor-intensive and relatively expensive due to bank fees. They are recommended for use in higher-risk situations, when the importer’s credit is unacceptable or not available, when dealing with a new or less-established trade relationship or when extended payment terms are requested.

The required documents are detailed and prone to errors and discrepancies. To avoid payment delays and extra fees, documents required by the Letter of Credit should be prepared by trained professionals.

Additionally, the exporter should consult with their bank before the importer applies for the Letter of Credit. Ask about:

• What type and size of export transactions are suitable for a Letter of Credit?? ?
• How much does a Letter of Credit cost? Who pays the fees?
• How are disputes resolved between importer and exporter?

How to Apply for a Letter of Credit

1. The exporter and their bank must be satisfied with the creditworthiness of the importer’s bank. Once the Sales Agreement is completed, the importer applies to their bank to open a Letter of Credit in favor of the exporter.
2. The Importer’s bank drafts the Letter of Credit using the Sales Agreement terms and conditions and transmits it to the exporter’s bank. The exporter’s bank reviews and approves the Letter of Credit and sends it to the exporter.
3. The exporter ships the goods in the manner provided for in the letter of credit and submits the required documents to their bank.? A freight forwarder may be used to assist in this process.
4. The Exporter’s bank checks the documents for compliance with the Letter of Credit terms and conditions. Any document errors and discrepancies must be amended and resubmitted. After approval, the exporter’s bank submits the complying documents to the importer’s bank.
5. The importer’s bank releases payment to the exporter’s bank. The importer’s account is and their bank releases the documents to the importer to claim the goods and clear customs.

How Much a Letter of Credit Costs

Banks usually charge a fee for a letter of credit, which can be a percentage of the total credit they are backing. The cost of a letter of credit will vary by bank and the size of the letter of credit. For example, the bank may charge 0.75% of the amount that it's guaranteeing.

Fees can also depend on the type of letter. In an import-export situation, an unconfirmed letter of credit is less costly. A confirmed letter of credit may have higher fees attached based on the issuing bank's credit strength.3

Types of Letters of Credit