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What are letters of credit?

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A letter of credit is a letter from a bank guaranteeing that a buyer’s payment to a seller will arrive on time and in the right amount. If the buyer cannot make a payment on the purchase, the bank must cover the full or remaining purchase amount.

How do letters of credit work?

Buyers making major purchases may need a letter of credit to show sellers that the payment will go through. When a bank issues a letter of credit, they are guaranteeing payment to the seller and taking responsibility for the payment. A buyer must show the bank that they have enough assets or credit to pay for the purchase before the bank will guarantee a payment to the seller.

How much does a letter of credit costs?

Banks usually charge a fee for a letter of credit—often, a percentage of the total credit that they will back. Letter of credit costs differ from bank to bank and depend on the size of the letter of credit. Fees can also change based on the type of letter.

Types of Letters of Credit

The types of letters of credit include a revolving letter of credit, traveler’s letter of credit, confirmed letter of credit, and a commercial letter of credit.

Revolving Letter of Credit

This letter allows a customer to make any draws within a limit and during a certain time period.

Traveler’s Letter of Credit

A traveler’s letter of credit guarantees that issuing banks will honor drafts made at foreign banks.

Confirmed Letter of Credit

A confirmed letter of credit involves multiple banks. The first guarantees the letter of credit and the second confirms payment under the letter of credit if the holder and the issuing bank default.

Commercial Letter of Credit

During this direct payment method, the bank makes the payments to the beneficiary.

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