Finance term
Letter of Credit
Also known as: LC, standby letter of credit, SBLC, documentary letter of credit
Definition
A letter of credit is a bank's written guarantee to pay a seller on behalf of a buyer when specific terms are met — commonly used in international trade to eliminate counterparty risk between importers and exporters.
Detailed explanation
A letter of credit (LC) is a formal commitment from a bank (the issuing bank, on behalf of the buyer) to pay the seller a specified amount when the seller presents documents proving the shipment terms have been met — bill of lading, commercial invoice, insurance certificate, and others as specified. The International Chamber of Commerce's UCP 600 rules govern most commercial letters of credit globally.
The two main types for small businesses: (1) Commercial/Documentary LC — payment triggered by documents confirming shipment (importer pays bank; bank pays exporter upon document presentation); (2) Standby LC (SBLC) — a payment guarantee triggered only if the applicant defaults, used as a performance bond or credit enhancement. Standby LCs are common in domestic commercial real estate and large contracts.
For small business importers, LC financing can be combined with SBA's Export Working Capital Program (EWCP) and EXIM Bank programs, which insure or guarantee export transactions. Letters of credit typically cost 0.5-3% of face value as a fee plus collateral requirements (cash, certificate of deposit, or existing credit facility capacity).
◈ Worked example
- A U.S. importer orders $200,000 in electronics from Taiwan. Their bank issues an LC to the Taiwanese exporter's bank: 'We will pay $200,000 when documents confirming shipment — bill of lading, commercial invoice, packing list — are presented.' Exporter ships, presents documents, gets paid.
- A commercial tenant is required to post a $50,000 standby LC as a security deposit instead of cash. The landlord holds the SBLC; if the tenant defaults on rent, they draw on it. The tenant's bank issues it against the tenant's existing credit line.
- LC fee example: $500,000 LC for 180 days at 1.5% annual fee = $3,750 issuing fee. Collateral: bank may require 100% cash margin or existing line of credit capacity.
Common questions
The most-asked questions about Letter of Credit — answered straightforwardly.
When would a small business need a letter of credit? +
Most commonly when importing goods from international suppliers who don't know you well enough to ship on open account (deferred payment). Suppliers in China, Southeast Asia, South America, and other markets often require LCs from new customers. As the relationship matures and trust is established, suppliers often migrate to open account or document against acceptance terms.
How much does a letter of credit cost? +
Fees range from 0.5-3% of the LC face value annually, depending on credit risk of the applicant, tenor (duration), and bank. There are also advising fees, amendment fees, and document examination fees charged by both the issuing bank and the correspondent bank. Total cost for a $100,000 LC might be $500-$3,000 plus $50-$100 in document fees.
What is the difference between a letter of credit and a letter of intent? +
Completely different instruments. A letter of credit is a bank payment guarantee — a financial obligation. A letter of intent (LOI) is a non-binding expression of intent to enter into a transaction — not a payment commitment. Letters of credit are issued by banks; letters of intent are written between the parties themselves.
Further reading
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