A letter of credit is an undertaking issued by a bank, on your instruction as the importer, to pay your overseas supplier a specified amount once the supplier presents documents proving they shipped the goods on the agreed terms. It exists to solve one problem: neither side wants to go first. The supplier does not want to ship before payment, and you do not want to pay before shipment.
The letter of credit resolves that standoff by putting a bank between the two of you. The supplier is no longer relying on your promise to pay; they are relying on the bank's. In exchange, the bank is relying on you, and it will assess you accordingly.
How the mechanism works
You agree commercial terms with your supplier and agree that payment will be by letter of credit. You then apply to your bank to issue one, setting out the amount, the goods, the shipping deadline, the expiry date and the exact documents the supplier must present.
The issuing bank sends the credit to a bank in the supplier's country, which advises the supplier that it exists. The supplier ships the goods and presents the required documents, typically a bill of lading, a commercial invoice, a packing list, an insurance certificate and whatever certificates of origin or inspection the credit specifies.
If the documents comply exactly with the terms of the credit, the bank pays. If they do not, the bank is not obliged to, and you are asked whether you will waive the discrepancy. That single word, exactly, is the whole practical difficulty with letters of credit.
Banks deal in documents, not goods
This is the point that catches importers out most often. The bank never inspects the shipment. It examines whether the paperwork matches the credit. A container of the wrong goods with perfect documents gets paid. The right goods with a misspelled consignee name or a bill of lading dated one day outside the shipping window do not, at least not without your waiver.
Discrepancies are common on first presentation, and every one of them costs a fee and a delay. Two habits reduce them substantially: write the document requirements yourself rather than accepting a template, keeping them as simple as the transaction allows, and send the supplier a copy of the credit early so they can check they can actually produce what it demands.
The variations worth knowing
Irrevocable is the standard. It cannot be amended or cancelled without every party agreeing. Treat anything revocable with suspicion.
Confirmed means a second bank, usually in the supplier's country, adds its own undertaking to pay. Suppliers ask for this when they are not comfortable with the issuing bank's country or credit standing. It costs more, and the cost is negotiable between you and the supplier.
At sight means the bank pays on presentation of compliant documents. A usance or deferred payment credit means the bank pays a set number of days after presentation or after the shipping date, which effectively gives you a credit period. That is often the cheapest working capital in the transaction.
A transferable credit allows the supplier to pass part of it to their own supplier, which matters when you are dealing with a trading intermediary rather than a manufacturer.
What it costs and what it ties up
There is an issuance fee, usually a percentage of the value with a minimum, plus amendment fees, discrepancy fees, and confirmation costs if the credit is confirmed. Amendments are avoidable and expensive, which is another argument for getting the terms right at the outset.
The larger cost is often the limit. A letter of credit is a contingent liability of the bank, so it uses your trade facility limit from issuance until it expires or is paid. Money sitting behind an open credit is not available for anything else, and a business running several concurrent credits can find its facility fully committed while nothing has actually been paid.
When a letter of credit is the wrong tool
With a supplier you have traded with for years, a letter of credit may be machinery you no longer need. Open account terms with trade credit insurance, or a documentary collection, are cheaper and lighter. Import finance vs letter of credit covers the choice between funding the purchase and guaranteeing it, which are different problems that get confused often.
And if the real issue is that you pay on shipment but sell on terms, the letter of credit does not touch it. That is a working capital gap between paying the supplier and being paid by your customer, and it wants an import or trade facility rather than a payment guarantee.
Where to from here
We arrange letters of credit and the wider trade finance range across our whole lender panel, including funders who will look at trade facilities for importers the majors consider too small. There are no fees to clients; the lender pays us when the finance settles. Book a 20-minute brief before you agree payment terms with a new supplier, not after.
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