A letter of credit is issued by a bank or other financial institution as a way to guarantee payment in the event the customer does not pay. This can be especially useful when conducting business internationally or when making large complex purchases where failure to receive payment could result in cash flow issues. Companies that have concerns about receiving timely payments from customers and that want to ensure no interruptions to company operations as a result of nonpayment from customers can request a small business letter of credit.
We recommend considering Bluevine from our list of the best cash flow lenders. It offers a line of credit up to $250,000 that you can use to draw funds on an as-needed basis. You pay only when using the credit line as there are no fees to open, maintain, or close the account.
Key takeaways
- With complex, high-risk, or large purchases, a letter of credit can facilitate a smooth transaction between a buyer and seller by providing the seller with a guarantee of payment.
- Buyers can request a letter of credit from financial institutions, which usually charge a fee between 0.5% and 1.5% of the transaction amount.
- Different types of letters exist, and terms can often be customized to suit the unique needs of a transaction.
- If a letter of credit is not an option, consider getting financing from other sources, such as loans, to temporarily allow your company to continue operating until you receive payment.
How a Letter of Credit Works
A letter of credit typically may come up as a requirement when a buyer wishes to purchase a product or service from a seller. If the seller needs additional assurance that the buyer will make payment in a timely manner, a letter of credit could be requested. This letter of credit can be issued by a bank, and it will guarantee that the seller will get paid by either the buyer or the bank.
Below are the major steps that illustrate a typical transaction where a letter of credit is requested.
Step 1: Buyer and seller agree to a business transaction.
Before a letter of credit is deemed necessary, a buyer and seller typically must first come to an agreement on the details of a transaction. This can be for the purchase of goods or services. Having the details of the proposed transaction gives the seller more information on whether it might warrant a letter of credit.
Step 2: Seller requests a letter of credit from the buyer.
Once the details of the transaction are finalized, the seller can then determine whether it would want a letter of credit. Some possible factors could include the dollar amount of the transaction, potential impact on the seller in the event of nonpayment, and other risk factors. If the seller would like a letter of credit, it can inform the buyer, who can then take the next steps in obtaining it from a bank or other financial institution.
Step 3: Buyer obtains a letter of credit from a bank or other financial institution.
A letter of credit for small business transactions can be obtained from banks, credit unions, and other financial institutions. To get a letter of credit, these institutions usually go through a review process similar to that of a loan. This is done to ensure that the risk of the buyer defaulting on the payment to the seller will be low, so it must ensure the buyer can demonstrate the ability to afford the payment.
If approved, the bank will issue a letter of credit outlining the details of the transaction and any other terms and conditions.
Step 4: Purchase of services/goods is completed.
Depending on the type of letter of credit issued, funds can be sent directly to the seller to complete the transaction. Otherwise, once the buyer has obtained the letter of credit, it can be provided to the seller with payment to follow at a later date. If this is the case and the buyer subsequently fails to make payment in a timely manner, the seller would receive payment from the bank that issued the letter of credit.
Small Business Letter of Credit Types
Different types of letters of credit exist, and each has its own nuances. The details of your business transaction will determine the type of letter of credit best suited to your needs:
- Commercial letter of credit: As its name suggests, it is used in commercial transactions. This can include those conducted domestically and internationally. With a commercial letter of credit, the issuing bank makes payment directly to the seller.
- Standby letter of credit: The issuing bank will require the buyer to first make payment to the seller. Unlike a commercial letter of credit, the bank only pays the seller if the buyer fails to do so in a timely manner.
- Revolving letter of credit: It is typically used if the buyer and seller have agreed to conduct multiple transactions. This can save time and money from having to apply for a new letter of credit for each individual transaction.
- Traveler’s letter of credit: It is typically an ideal fit for those traveling overseas. This type guarantees that drafts will be honored at specified international banks.
- Confirmed letter of credit: Although unlikely, there’s always the chance that a bank issuing a letter of credit could also default or be unable to honor its agreement. A confirmed letter of credit significantly reduces this risk, as it guarantees that the seller can get paid by its own bank if the buyer and buyer’s bank default.
When a Letter of Credit Typically Is Required
The seller of a product or service can determine the circumstances in which they’d like to get a letter of credit from a buyer. This can be dependent on the characteristics of the buyer, the details of the transaction, or other factors. Below are common circumstances in which a letter of credit might usually be involved:
- The transaction is being conducted internationally: Conducting business overseas can be particularly challenging and complex, especially when factoring in differences in business law. A letter of credit can not only help provide a guarantee of payment, but it can also specify details of how the transaction must be completed to ensure it’s completed more efficiently. Details can include things like when goods must arrive and when payment must be made.
- The transaction is for a large dollar amount: If the transaction being conducted is for a large amount of money or is otherwise more complex, a letter of credit can give the seller peace of mind in knowing they’ll get paid. This can be beneficial to sellers if they must incur significant expenses to fulfill the order, where failure to receive payment could cause cash flow issues.
- The buyer and seller have never conducted business before: Without a track record of doing business, a seller may not know how reliable a buyer is with regard to making timely payments. A letter of credit can give sellers the guarantee of being paid.
Pros & Cons of a Small Business Letter of Credit
| PROS | CONS |
|---|---|
| Helps ensure payment to sellers | Can increase the time to complete the transaction if it’s required |
| Has terms that can be written to provide clarity on payment timing and delivery of products or services | Can’t be obtained for free as financial institutions often charge buyers a fee to get a letter of credit |
| Has different types that can be used for a wide range of transaction types | Is not offered by all financial institutions |
How To Get a Letter of Credit
Getting a letter of credit has many similarities to getting a traditional loan. You’ll need to find a bank that can issue one, submit an application, and provide any requested documentation.
We recommend checking out our guide on how to get a small business loan as we cover common eligibility criteria and documentation requirements. However, keep in mind that the exact criteria may vary slightly depending on the lender you choose.
Wells Fargo is one example of a lender that offers letters of credit. You can apply for a commercial or a standby letter of credit, both of which are secured by deposits you have with the bank. The provider also offers other lending and banking services that you can utilize as a small business owner.
Frequently Asked Questions (FAQs)
Most institutions can issue a letter of credit within 10 to 14 business days. During this time, the buyer’s qualifications must be reviewed by the issuing bank, which can include a review of its credit, income, and assets.
Buyers must typically pay between 0.5% and 1.5% of the value of the transaction to get a letter of credit. The exact amount can vary depending on the amount and complexity of the transaction, as well as the requested terms and qualifications of the buyer.
If a buyer ends up not paying for goods or services, a letter of credit ensures that the seller still gets paid by the bank that issued the document. Sellers can get added security with this guarantee, while buyers can secure an agreement on the purchase of a product or service that they might not otherwise have been able to get.
Bottom Line
Different types of letters of credit exist depending on the details of your transaction, but they all serve the primary purpose of ensuring the seller of a product or service will get paid. They are often used in international transactions and in large complex purchases. This can be helpful if receipt of funds is critical to continued business operations.
However, while letters of credit carry many benefits, also consider the downsides, such as the time needed to get one and the fees that may be charged by the issuing bank.
