A letter of credit is a written promise from a bank that payment will be made
A letter of credit is a document issued by a bank on behalf of a buyer, guaranteeing that the seller will receive payment for goods or services — as long as the seller meets specific conditions laid out in the letter. The bank promises to pay the seller directly, not the buyer. This protects both sides: the seller knows payment is backed by a bank, and the buyer does not have to send money before receiving the goods.
Letters of credit are used most often in international trade, where buyer and seller do not know each other and are in different countries. A U.S. importer buying fabric from a supplier in India, for example, might use a letter of credit so the Indian supplier feels confident shipping the goods without payment upfront. The bank steps in as the middleman and guarantees the money.
The letter of credit is not a loan. The bank is not lending money to the buyer. Instead, the bank is lending its reputation and promise to pay, which makes the transaction possible when trust alone would not.
Key Takeaways
- A letter of credit is a bank's written promise to pay a seller on behalf of a buyer, provided the seller meets the conditions in the letter.
- The seller receives payment from the bank after submitting proof that goods were shipped or services were delivered, not from the buyer directly.
- Letters of credit are most common in international trade when the buyer and seller do not have an existing relationship.
- The buyer's bank charges a fee for issuing the letter, usually a percentage of the total amount may provide.
How a letter of credit works step by step
The process begins when a buyer and seller agree on a sale. The buyer asks their bank to issue a letter of credit in favor of the seller. The buyer's bank then sends the letter to the seller's bank (or directly to the seller if no bank is involved on the seller's side).
The letter spells out exactly what the seller must do to get paid. Common conditions include: the goods must be shipped by a certain date, the seller must provide a bill of lading (proof of shipment), an invoice, and insurance documents. The seller then ships the goods and gathers all the required paperwork.
Once the seller has all the documents, they submit them to their bank or directly to the buyer's bank. The bank checks that every document matches the conditions in the letter of credit. If everything is in order, the bank pays the seller. The buyer then receives the documents and can claim the goods from the shipping company.
If the seller's documents do not match the letter's conditions — for example, if the shipment arrives after the deadline stated in the letter — the bank will not pay unless the buyer agrees to accept the discrepancy.
Types of letters of credit and what each one means
A revocable letter of credit can be changed or canceled by the buyer's bank at any time without notice to the seller. This offers little protection to the seller and is rarely used in modern trade.
An irrevocable letter of credit cannot be changed or canceled without the agreement of both the buyer and the seller. This is the standard in international trade because it gives the seller real protection. Once issued, the bank's promise stands.
A confirmed letter of credit means the seller's bank adds its own promise to pay on top of the buyer's bank's promise. If the buyer's bank fails to pay, the seller's bank will. This is the strongest protection for the seller and is common when the buyer's bank is in a country with currency or political risk.
A standby letter of credit works differently. It is a backup promise to pay, used only if the buyer fails to pay as promised. For example, a contractor might require a standby letter of credit from a project owner, so if the owner does not pay the final invoice, the contractor can draw on the letter instead.
What the buyer and seller each pay for
The buyer pays a fee to their bank for issuing the letter of credit. This fee is usually between 0.5% and 2% of the letter's face value, depending on the bank, the buyer's creditworthiness, and the country involved. A letter of credit for $100,000 might cost the buyer $500 to $2,000.
The buyer may also pay for amendments if the letter needs to be changed after it is issued — for example, if the shipment date moves or the amount changes. Each amendment typically costs $100 to $300.
The seller may pay a fee to their bank for reviewing and presenting the documents, though this is less common and often waived for regular customers. Some banks charge $50 to $200 to handle the paperwork.
Neither the buyer nor the seller pays the bank's fee to the other side's bank. Each party pays only their own bank.
When a letter of credit is used and when it is not
Letters of credit are most common in international trade for goods — textiles, machinery, raw materials, electronics. They are used when the buyer and seller do not have a long history together, when the sale is large, or when the buyer is in a country where currency is unstable or political risk is high.
They are less common in domestic trade within the United States, where the buyer and seller can use other methods like wire transfers, credit cards, or payment on delivery. Letters of credit are also rare for services, because services are harder to document and verify than physical goods.
Some industries use letters of credit routinely. Import-export companies, manufacturers buying raw materials from overseas, and construction firms bidding on large projects often work with them. Small businesses or one-time purchases usually do not.
What can go wrong and how banks handle disputes
The most common problem is a discrepancy between the documents the seller submits and the conditions in the letter of credit. If the invoice shows a slightly different amount, or the shipment date is one day late, or the bill of lading lists the wrong port, the bank will reject the documents and refuse to pay.
When this happens, the seller can ask the buyer to waive the discrepancy — to agree that the documents are close enough. If the buyer agrees, the bank will pay. If the buyer refuses, the seller does not get paid and must decide whether to pursue the matter in court or absorb the loss.
Another risk is fraud. If a seller submits forged documents — a fake bill of lading, for example — the bank may not discover it before paying. The buyer then has to pursue the seller in court, which is difficult and expensive if the seller is overseas.
Banks are required to check documents carefully but are not responsible for verifying that goods actually match the description or that they arrived in good condition. The bank's job is only to confirm that the paperwork matches the letter's conditions.
How a letter of credit differs from other payment methods
A wire transfer is direct payment from buyer to seller with no bank may provide. The buyer sends money and hopes the seller ships the goods. The seller has no may provide of payment until the money arrives. A letter of credit protects both sides.
A documentary collection (also called a draft) is similar to a letter of credit but cheaper and simpler. The seller ships the goods and sends the documents to their bank, which forwards them to the buyer's bank. The buyer's bank releases the documents only when the buyer pays or agrees to pay. There is no bank may provide — only a promise to hold the documents until payment clears. This works well for repeat customers but offers less protection than a letter of credit.
A credit card offers buyer protection but not seller protection. The buyer can dispute the charge if the goods do not arrive or are damaged. The seller has no may provide the buyer will not reverse the charge.
A payment on delivery arrangement means the buyer pays the shipping company when the goods arrive. The seller ships first and trusts the buyer will pay. This is risky for the seller if the buyer refuses to accept the shipment.
Frequently Asked Questions
Does a letter of credit may provide the buyer will pay?
No. A letter of credit guarantees the bank will pay the seller if the seller meets the conditions in the letter. The buyer still has to reimburse the bank. If the buyer cannot pay, the bank may pursue the buyer for the money, but the seller has already been paid and is not affected.
Can a seller refuse a letter of credit?
Yes. A seller can ask for a different payment method if they do not trust the buyer's bank or if the conditions in the letter are too strict. Some sellers prefer wire transfer or payment in advance. The payment method is negotiated between buyer and seller.
How long does it take to get paid with a letter of credit?
Once the seller submits the correct documents, payment usually arrives within 5 to 10 business days. The bank needs time to review the paperwork and process the transfer. If there are discrepancies, payment can be delayed by weeks while the buyer decides whether to waive them.
What happens if the buyer's bank fails before paying?
If the letter of credit is irrevocable and confirmed, the seller's bank has already promised to pay, so the seller is protected. If the letter is irrevocable but not confirmed, the seller may have to wait or pursue the buyer's bank in court. This is why sellers in risky countries often request a confirmed letter of credit.
Can a letter of credit be used for services instead of goods?
Technically yes, but it is uncommon. Services are hard to document and verify the way goods are. A bank cannot easily confirm that a consulting project or software development was completed as promised. Letters of credit work best for tangible goods with clear proof of shipment.