For centuries, letters of credit have been the primary monetary agreement between buyers and sellers. In this article, we'll discuss a few types and how they are usually applied.
Letters of Credit: A Definition
This financial tool reassures buyers and sellers because it guarantees that payment for goods or services will be received. This is not a reliance on an invoice system but a secured promise of payment in advance.
Once the goods are services have been rendered, the parties report the transaction to the bank through shipping documents or a processed request that confirms both the buyer and seller upheld the agreement.
Letters of credit are most often used to eliminate the potential risk in dealing with online merchants, new business transactions and international trade.
The easiest way to understand what a letter of credit does is to consider traveler's checks. You, as the buyer (traveler), have already purchased a document stating that the payment will be good - the traveler's check. When presented to the seller, such as a hotel, restaurant or retail merchant, they are automatically reassured they will receive payment.
Various Types of Letters of Credit
A commercial letter of credit was best outlined in the definition above. A bank reinforces backing of payment for both a buyer and a seller. Depending on the individual business agreement with the bank, each party can protect themselves in this way to safeguard transactions.
Standby Letter or Performance Bond
This is a guarantee on behalf of the bank or client that compensation will still be issued, even if there is a failure of action by a third party. This may be the bank's agreement to a third party that if the bank's client doesn't fulfill the contract, the bank will.
The assurance of monetary retribution may also be guaranteed through an insurance bond or policy or a pre-established escrow account.
A cofirmed letter of credit is, basically, an insurance policy on your insurance policy. If the first bank, commonly referred to as the issuer, refuses payment for any reason, the second bank, provider of the confirmed letter, still comes through on payment or drafts off the account. Most often used in international transactions.
A real estate letter of credit is being used more often, and many homebuyers find it very attractive, especially when it comes to new construction. Basically, instead of putting the standard 20 percent down on a mortgage, potential buyers pay a small cash advance and secure the rest of the down payment with this document. Contractors can continue building, secure in the presale of the unit, and buyers don't have to have that 20 percent right away.
Customers with reliable employment, a good credit score and a large enough liquid availability of assets, such as checking and savings accounts, CDs and stocks can qualify for an unsecured letter of credit. This is often used for real estate transactions and new business development.
Resources and Application
Depending on the intended use, it's best to sit down with a financial advisor or bank representative to go through the application process. All assets will be taken into consideration and attributed accordingly.
A few other resources that may prove helpful:
- The Chicago Board of Trade examines the use of letters for investment purposes.