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Letter of Credit Explained
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It is the most protective payment method for both sides, and the most unforgiving about detail.
| Term | Meaning |
|---|---|
| Irrevocable | Cannot be changed without all parties agreeing |
| At sight | Paid on presentation of compliant documents |
| Usance or deferred | Paid a set period after presentation |
| Confirmed | A second bank adds its own guarantee |
| Discrepancy | A document mismatch that can block payment |
How does a letter of credit work?
The sequence is fixed and worth knowing before you agree to one.
You and the seller agree the terms, including exactly which documents will be required. You apply to your bank, the issuing bank, which issues the credit in the seller's favour and sends it through the seller's bank. The seller checks the credit is workable, then ships the goods and assembles the specified documents: typically the bill of lading, commercial invoice, packing list, insurance certificate and often a certificate of origin.
The seller presents those documents to their bank, which forwards them. The issuing bank examines them against the credit. If they comply, the bank pays and releases the documents to you, and you use the bill of lading to collect the cargo. If they do not comply, you have a discrepancy, and payment stops until it is resolved or you waive it.
What does "banks deal in documents" mean for me?
It means the bank is not checking your goods. It is checking paper.
If the documents match the credit exactly, the bank pays, even if what actually arrives is not what you hoped for. If the documents do not match, the bank can refuse, even if the goods are perfect. A letter of credit protects you against a seller who ships nothing, and against paying before shipment. It does not protect you against a seller who ships poor quality.
That is why a letter of credit is not a substitute for inspection. Pair it with the controls in our guide on quality control, and consider requiring an inspection certificate as one of the documents in the credit itself, which is a practical way to link payment to quality.
What are discrepancies and why do they matter?
A discrepancy is any mismatch between the documents presented and the credit's terms. A name spelled differently, a description that does not match word for word, a shipment date outside the window, an amount slightly over. A significant share of first presentations contain at least one.
When a discrepancy is found, the bank is entitled to refuse payment. In practice you are usually asked whether to waive it, and most are waived, but it costs time, fees and leverage. Both sides should therefore read the credit carefully at issuance, before shipment, and fix anything unworkable then. Amending a credit after issuance costs fees and delay.
When should I use one, and when not?
Use a letter of credit when the order is large, when it is a first transaction with a supplier you have not worked with, when either party needs financing security, or where it is the customary instrument in that trade.
Do not use one for small routine orders with an established supplier, where the bank fees and administration are disproportionate to the risk. A plain telegraphic transfer is simpler and cheaper, and once trust is established most ongoing relationships settle there. Our guide on paying Japanese suppliers compares the methods and their protection.
One Japan-specific note: where a trading company sits between you and the manufacturer, the credit is often issued in the trading company's name rather than the maker's, which our guide on trading company versus manufacturer explains.
Frequently asked questions
How does a letter of credit protect the buyer?
It ensures the seller is only paid once they present documents proving shipment on the agreed terms, so you are not paying in advance and hoping. It does not guarantee quality, because banks examine documents rather than goods.
What is the difference between a sight and a usance letter of credit?
A sight credit is paid on presentation of compliant documents. A usance or deferred credit is paid a set period afterwards, for example 60 or 90 days, which effectively gives the buyer credit terms.
What is a confirmed letter of credit?
One where a second bank, usually in the seller's country, adds its own undertaking to pay alongside the issuing bank. Sellers ask for confirmation when they are not comfortable with the issuing bank or its country risk.
What happens if there is a discrepancy?
The bank may refuse to pay until it is resolved or the buyer waives it. Most are waived in practice, but it costs time and fees, so both parties should check the credit terms carefully before shipment.
Is a letter of credit expensive?
There are issuance, amendment, presentation and often confirmation fees, which make it disproportionate for small routine orders but reasonable insurance on a large or first transaction.
Related terms
See the full trade terms glossary, or read about the bill of lading, which is normally the key document a credit requires.
This guide is general information for overseas buyers, not banking, financial or legal advice. Terms and practice vary by bank and by the rules the credit is issued under.
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