Letter of credit is a document issued by a bank which guarantees the payment of a customer’s drafts for a specified period and up to a specified amount.
Letters of credit are commonly used today in international trade when a supplier in one country does business with a wholesaler in another country. If business A wanted to purchase a large order of supplies from business B, business A would go to their own bank and request a letter of credit.
When business A is approved, their bank will send the letter of credit to business B’s bank. Business B’s bank will then notify business B that the letter of credit was received and they can now ship the order with full assurance of payment.
When the proper documents are presented as stipulated in the contract, business A’s banks will transfer the payment to business B’s bank which will then credit business B’s account. The banks only deal with the documents and not the transaction itself.
Letters of credit can also be used in the process of land development to make sure that previously approved public projects will be completed. These projects can include sidewalks, sewers, and streets.
The parties involved in a letter of credit are the beneficiary, the issuing bank, and the advising bank. The beneficiary is the party receiving the money. The issuing bank is the bank of the applicant and the advising bank is the bank of the beneficiary. The applicant, however, is not included in the parties of a letter of credit.