Definition
A letter of credit is a commitment by the buyer's bank to pay the seller a set amount, provided the seller presents documents that exactly match the terms, such as a commercial invoice, bill of lading, and packing list. It replaces the buyer's credit risk with the bank's, making it common in international trade between new partners.
Also called: LC, L/C, Documentary credit
Letter of credit in practice
Most letters of credit follow the ICC's Uniform Customs and Practice for Documentary Credits (UCP 600). Banks check documents, not goods, so a spelling difference or wrong date on the invoice can cause a discrepancy and delay or block payment.
A confirmed letter of credit adds a second bank, often in the seller's country, that also guarantees payment, protecting the seller if the buyer's bank or country becomes a risk.
Letters of credit cost fees on both sides and take time to arrange, so they are mostly used for larger shipments. For smaller or repeat deals, documentary collection or open account terms are cheaper.
Example
A Brazilian buyer opens a letter of credit for $85,000 in favor of an Italian machinery maker. After shipping, the maker presents the invoice, bill of lading, and insurance certificate to its bank and is paid once the documents are found compliant.
Frequently Asked Questions
What happens if invoice details do not match the letter of credit?
The bank can refuse the documents as discrepant. The buyer may waive the discrepancy, but payment is delayed and no longer guaranteed. Copy descriptions and figures exactly from the credit.
Is a letter of credit the same as a bank guarantee?
Not quite. A letter of credit is the normal payment route. A bank guarantee, or standby letter of credit, pays only if the buyer fails to pay.
Related terms
- Bill of lading A bill of lading is a document issued by a carrier to the shipper that acts as a receipt for goods loaded, evidence of the contract of carriage, and, when negotiable, a document of title.
- Commercial invoice A commercial invoice is the official invoice used for international shipments that customs authorities rely on to assess duties and taxes.
- Cash in advance Cash in advance (CIA) is a payment term requiring the buyer to pay the full amount before the seller ships goods or starts work.
- Incoterms Incoterms are standard three-letter trade terms published by the International Chamber of Commerce that define who pays for shipping, insurance, and customs, and where risk passes from seller to buyer in an international sale.
This page is for general information only and is not legal, tax, or financial advice. Rules change and vary by location, so consult a qualified lawyer or accountant about your situation.