When someone trades inside or outside India, the sellers often require a guarantee that they will get the correct payment from the buyer in a stipulated time period. Letter of credit and bank guarantee are two such guarantees which a buyer can get issued from bank and give to the seller
So they both guarantee on your behalf that the payment will get received to seller and he can provide his services to buyer. They eliminate the risk for exporter or seller.
Letter of Credit
- A letter of credit is a letter issued by bank which guarantees seller’s payment on time and in correct amount up to the time the services will be delivered to the buyer.
- So, it ensures that the transaction of money will go as planned by the bank.
- Example: You purchase some material from a seller and that material is to come on continuous basis for a month, you can get issue a letter of credit from bank and give to the seller which will ensure that the seller will receive his payments on regular basis. So the seller will believe more on the letter of credit issued than you for the payments.
- It can be used when someone imports goods from another country. In this case also a letter of credit can be given to seller.
- Most of the time the seller himself asks for a letter of credit from the buyer.
- It eliminates the financial risk because payment is to come from a bank.
Letter of Credit types:
There are four types of Letters of Credit and they are given below.
- A revocable letter of credit
- An irrevocable letter of credit
- A standby letter of credit
- Revolving letter of credit
Revocable Letter of Credit:
As the name suggests, letter of credit can be revoked by the issuing bank without the beneficiary’s assent or agreement.
Irrevocable Letter of Credit:
An irrevocable letter of credit is a financial instrument used by banks to guarantee a buyer’s obligations to a seller. It is irrevocable because the letter of credit cannot be modified unless all parties agree to the modifications.
Irrevocable letters of credit are often used to facilitate international trade because of the additional risks involved. The irrevocable letter of credit assures the seller that it will be paid by the bank if the buyer fails to pay.
Standby Letter of Credit:
Guarantee of Payment: If the beneficiary is not paid from its customer, it can then demand the payment from the Bank by forwarding the copy of the invoice that was not paid and the supporting documentation.
Revolving Letter of Credit:
This is implemented when there are regular shipments of the same commodity between the supplier and the customer. The said procedure eliminates the need to issue a Letter of Credit for every individual transaction.
Letter of undertaking (LOU) is a form of bank guarantee under which a bank can allow its customer to raise money from another Indian bank’s foreign branch in the form of a short term credit
- Bank guarantee also has the functions as are of letter of credit with a small distinction.
- Unlike in letter of credit, in a bank guarantee the payment is done only when the buyer is not able to pay the required amount of money to the seller.
- Example: Same example can be taken; you buy material or import something to country, you can give a bank guarantee letter to exporter that will say that if you do not provide the payment, then bank will provide that on your behalf.
Bank guarantee types:
There are two major types of bank guarantee used in businesses, which are as follows:
Financial Guarantee – These guarantees are generally issued in lieu of security deposits. Some contracts may require a financial commitment from the buyer such as a security deposit. In such cases, instead of depositing the money, the buyer can provide the seller with a financial bank guarantee using which the seller can be compensated in case of any loss.
Performance Guarantee – These guarantees are issued for the performance of a contract or an obligation. In case, there is a default in the performance, non-performance or short performance of a contract, the beneficiary’s loss will be made good by the bank. For example, A enters into a contract with B for completion of a certain project and the contract is supported by a bank guarantee. If A does not complete the project on time and does not compensate B for the loss, B can claim the loss from the bank with the bank guarantee provided.
Difference between LoC and Bank Guarantee:
LOC is a financial document which imposes an obligation on the bank to make a payment to the beneficiary on completion of certain services as required by the applicant. LOC is issued by the bank when the buyer requests his bank to make a payment to the seller on the receipt of certain goods or services.
On the other hand, under BG, the bank is required to make payment to a third-party only if the applicant fails to make the payment to the third-party or does not fulfil the required obligations under the contract. A BG is essentially used to ensure a seller from loss or damage due to the non-performance by the other party in a contract.
So the difference between the two is that if you give letter of credit to seller, that will ensure that bank will pay on your behalf up to the day the services are being provided to you by the seller and if you give bank guarantee to seller, that will ensure that bank will pay on your behalf if you are not able to pay the amount.
Banks can apply charges to issue both letter of credit and bank guarantee.