What is a letter of credit in simple words? This question can often be found on the expanses of the World Wide Web. Many people believe that this word is used to refer to some complex term that is incomprehensible to an ordinary person, but in reality everything is simpler than it seems. In our article today we will describe in detail what a letter of credit is in a bank. Interested in? Then get started!
What is a letter of credit in simple words?
We will not beat around the bush, but immediately give an answer to your question. In simple terms, a letter of credit is one of the best and most reliable ways to protect your organization from the risks associated with prepayments for financial transactions. A letter of credit provides an opportunity to insure yourself in cooperation with new partners. In this situation, the bank is an intermediary, which temporarily stores monetary amounts in a special account. He also acts as a kind of guarantor, who takes responsibility for the payment of finances. This creates favorable conditions for both the supplier and the recipient.
Letter of credit - a special bank account giving the right to reserve the finances located on it during trade relations. If both parties comply with the terms of the contract, the bank must pay a certain amount of money to the recipient.
Where is the letter of credit used?
A letter of credit in a bank in simple words - what is this? We think that everything is clear with this question. Now let's find out where it is used. As a rule, these calculation forms are most often used in the business sector: the entrepreneur who ordered the goods can be sure that the finances will be removed from his work account only after shipment. The supplier, in turn, can be sure that he will receive his well-deserved cash payment. Funds are transferred only when the bank receives the necessary documents. In addition, the letter of credit form of payment is often used when concluding large transactions of the type of purchase and sale.
How does a letter of credit work?
In order to answer this question, you just need to familiarize yourself with the algorithm of actions of the parties that decided to use the calculation form we are discussing:
- The supplier announces the opening of the letter of credit in writing, after which a bank account is assigned to it.
- After receiving the goods, the buyer provides the bank with documents that confirm the fulfillment of the terms of the contract with the supplier.
- When the above procedures are done, a pre-negotiated amount of money is withdrawn from the buyer's account.
Withdrawals can be made by both the payer bank and the recipient bank.
Letter of credit agreement
In addition to what a letter of credit is in simple words, you also need to know what is needed to conduct a transaction.
The document that governs the relationship of the parties contains all the information necessary to complete the transaction. In the contract are fixed:
- Type of form used.
- The cost of the commission.
- Details of the participants.
- Bookable amount of finance.
- Instructions required in case of default.
- Terms of a letter of credit.
- The order of payments.
- Rights and obligations of both parties.
Types of letters of credit
The following types of letters of credit in the bank:
| Covered (deposited) | Most commonly used. From the very beginning, funds are transferred to the account of the receiving bank |
| Uncovered | The executing bank is given the right to withhold funds from the correspondent account within the amount of money specified in the contract |
| Revocable | The issuer may cancel the transfer of funds if the payer draws up a written order. Consent of the recipient is not required |
| Irrevocable | The agreement is canceled only when the seller gives consent |
| Confirmed (revocable / irrevocable) | Payments are made by the contractor even if there are no funds in the payer's account |
| Spare | The bank that opened the account may provide a written commitment to the seller about the payment history in the event that the buyer does not fulfill the terms of the contract. In this situation, the buyer will fulfill all obligations to the supplier |
| Revolving | As a rule, they open to a part of the full amount of the payment, and after charging the funds by the buyer it resumes to the amount indicated earlier. It is used in areas where goods are delivered on a specific schedule. |
| Circular | Gives the right to receive funds under a letter of credit in all correspondents of an advising credit institution |
| With a red reservation | According to the issuer's instructions, the advising banking organization credits the seller with finances before he submits documents confirming delivery |
Now let's take a closer look at the most popular ones.
Covered and Uncoated
Deposited and guaranteed transactions are the most commonly used letters of credit. The types of contracts determine the specification of the operations themselves.
- Covered operation. In this case, when issuing a letter of credit, the issuing bank transfers funds through the payer's account to the entire amount of the letter of credit. Finances are placed at the complete disposal of the executing bank for the entire duration of the transaction.
- Uncoated operation. Guaranteed banking operation provides for the transfer of funds by the issuing bank. The executing credit organization is given the opportunity to withdraw finances from its current account within the value of the letter of credit. The procedure for withdrawing money from an account held with the issuing bank is determined by special agreements between financial institutions.
Revocable and irrevocable
In second place in demand are revocable and irrevocable. They also have their own specific features.
- Revocable operation. The issuing bank has the full right to modernize or completely cancel the revocable banking operation. The basis for revocation of a letter of credit may be a written order from the payer. In this case, coordination with the recipient is not required. After carrying out this procedure, the issuing bank does not bear any responsibility to the payer.
- Irrevocable operation. A trouble-free letter of credit can only be canceled if the recipient agrees to a change in the terms of the contract. A partial change of conditions is not considered in this situation.
The recipient of funds for a banking operation may refuse to pay, but until the expiration of its term and provided that this has been agreed in the agreement. By prior arrangement, the acceptance of a third party who has the rights of a payer is also permitted.
Pros and cons
In addition to what a letter of credit is in simple words, many are also interested in the advantages and disadvantages of this phenomenon.
Unambiguous pluses include:
- Legal control of the contract.
- The possibility of obtaining excess profits from the buyer's account.
- Reducing the risk of not receiving the amount that was agreed in the agreement.
- Warranty for the buyer to receive delivery on time.
- The right to save on interest payments (which cannot be done in a regular loan).
If we consider the letters of credit objectively, then it is also worth talking about their disadvantages:
- Duration of the contract due to the large number of documents.
- The possibility of limiting the transaction by the state.
- Dear commission.
- Funds are not credited to the recipient's account without providing the documents specified in the preparation of the contract.
Mutual settlements
When concluding a contract, it is necessary to indicate in the contract a form of mutual settlements, as well as a scheme for the provision of services or particulars of the delivery of goods. In addition, the planned types of letters of credit and their features are registered in the papers. In order to avoid problems in the future, the following information should be in the contract:
- Name of the issuing bank.
- Identity of the recipient of the finance.
- The name of the financial institution that serves the payee.
- The amount of the cash amount of a banking operation.
- Species that both sides are going to use.
- A method of informing the recipient of funds about opening a transaction in a bank.
- The method of informing the payer necessary for depositing money.
- The term of the letter of credit, the timing of the provision of important securities and the rules for their execution.
- Features of the payment transaction.
Letter of credit transactions
Services on letters of credit can be implemented in various ways, it all depends on the credit institution. As a rule, banks conduct such operations:
- Service opening. The Bank opens a financial liability after a customer statement. In order to realize this obligation, the bank, on behalf of the applicant, must transfer the amount of money in favor of the seller of goods or real estate. In addition, the issuer may entrust the execution of this obligation to another bank after checking all important securities.
- Confirmation of commitment. The bank draws up a guarantee of payment of a letter of credit, which was drawn up by another banking organization.
- Advising a letter of credit. Notification to a credit institution that a letter of credit has been opened, amended or closed. The official notice is usually sent by letter, fax or any other electronic means of communication. After checking the securities, the bank informs the seller about issuing the invoice for the amount specified in the contract. Advising is controlled by the law, therefore, in order to avoid violations, banks devote a lot of time and effort to this process.
- Fulfillment of the obligation. The first stage consists of checking the submitted papers from the recipient of finance. When two banks participate in the transaction, the performing party must advise the issuing bank of the payment. Such an order is permissible only if the documents comply with the terms of the contract. If the documents do not meet these conditions, then the obligation is not fulfilled. Payment becomes possible when the buyer agrees to accept documents with defects.
What you should pay attention to?
What is a letter of credit in simple words, we have already discussed. In the end, we will pay attention to several important points.
For the partnership to be successful, the payer must study this format of banking operations on his own or with the help of a professional. Letters of credit differ depending on the form of mutual settlements. For a specific case, you need to choose the optimal form of partnership.
Credit - in simple words what? We hope we were able to give a clear and understandable answer to this question!