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Letter of Credit | What is an LC

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Many of people have asked me what an LC is. I will keep the explanation simple and logic, so no confusions are made. A letter of credit is a payment document used by a buyer to pay for goods to a supplier. A letter of credit is issued by a financial institution (most of the times by a bank).

An LC is released after both parties (buyer and seller) have agreed upon a business deal and have signed a contract. The letter of credit is just a financial document that guarantees payment to the supplier in case the clauses in the contract have been fulfilled and respected. Many big buyers chose to pay by letter of credit to avoid any risks that supplier will not deliver or will not respect the clauses in the contract.

How it works:
The buyer goes to his bank and asks them to issue a letter of credit for the supplier. The bank checks if the buyer has enough money in his account to pay for the value of the goods or services specified in the contract. Afterwords, the bank freezes the amount of money that the LC is issued for from the buyers account.

The buyer will not be able to move that money, but the supplier will not get paid until the goods have been delivered.

After the goods are delivered, the supplier (seller) will be able to get the contract amount paid by his bank to his account, only after providing proof that contract clauses have been fulfilled (usually by presenting export and relevant documents).

Broadly, this is what a letter of credit is all about. It’s kind of like using PayPal to pay on E-bay. An LC can be irrevocable or revocable. An irrevocable LC cannot be changed unless both buyer and seller agree. With a revocable LC, changes can be made without the consent of the beneficiary.

A sight LC means that payment is made immediately to the beneficiary/seller/exporter upon presentation of the correct documents in the required time frame. A time or date LC will specify when payment will be made at a future date and upon presentation of the required documents.

Letters of credit could be a lot of headakes especially for suppliers. Sometimes if there’s only a minor typing mistake or something is not specified in the export documents, the beneficiary of the LC has to file the claiming process over again. This means re-making documents, and paying extra fees to the bank.

This is why most suppliers prefer payment by TT (wire transfer).

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