How a Letter of Credit Works
Protection for Payments
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A letter of credit is a document from a bank that guarantees payment. While there are several types of letters of credit, they are often used when buying and selling: if a buyer fails to pay a seller, the bank that issued a letter of credit will pay the seller (assuming all requirements are met).
Letters of credit can also protect buyers. If you pay somebody to provide a product or service – and they fail to deliver – the buyer might be able to get paid using a standby letter of credit.
That payment can serve as a penalty to the company that failed to perform, and it’s similar to a refund, allowing the buyer to pay somebody else to provide the product or service needed.
If you're familiar with escrow services, the concept is similar: banks act as "disinterested" third parties (they don't take anybody's side), and they release funds only after certain conditions are met. Letters of credit are common in international trade, but they are also used in domestic transactions (such as construction projects).
Key points:
- A letter of credit provides protection for sellers (or buyers)
- Banks issue letters of credit when a business “applies” for one and has the assets or credit to get approved
- Letters of credit are complicated, and it’s easy to make an expensive mistake when using one
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