What is a Letter of Credit?

Letters of credit have been around almost as long as commercial trade itself. A letter of credit is a guarantee from the buyer’s bank that states the payment of a buyer’s obligation will be received on time and in the correct amount. Letters of credit take many forms; a standby letter of credit is used for multiple transactions while a commercial letter of credit is used for just one.

Typically, a business will require a letter of credit from a buyer when they're unsure of the risk; specifically, if the buyer is perceived to have a higher risk of non-payment because they are new to the business, and/or if the buyer is foreign.

A commercial letter of credit cost is up to 3% of the total transaction amount, with other letters of credit fees included. 

What are the drawbacks of letters of credit?

In today’s digital world, letters of credit can be a cumbersome, expensive, and time-consuming tool for facilitating a transaction. More importantly, letters of credit place a burden on buyers at a time when they want a transaction to go as smoothly and as quickly as possible.

Consider the following issues buyers often face with letters of credit:

• It is up to the buyer, not the seller, to obtain and pay for any letters of credit.
• For commercial letters of credit, buyers must obtain a letter from their banks for every shipment.
• Letters of credit can tie up the buyer’s lines of credit with its bank, reducing their financial flexibility.
• Even the smallest errors or problems with a letter of credit can cause a bank involved to refuse to issue payment once the shipment arrives.
• The claims process can be lengthy and laborious and can be derailed by minor discrepancies in paperwork.

Because of these drawbacks, buyers may resist using letters of credit, especially if they are used to dealing with open account terms that allow payment after they have received a shipment.

Fortunately, there are alternatives to letters of credit—such as trade credit insurance—that offer a more convenient and inexpensive option to streamline a transaction. 

Credit Insurance vs. Letters of Credit

Trade credit insurance offers a similar guarantee of payment as a letter of credit, but without the added costs and burdens. This solution is unlike letters of credit because it’s not just one transaction through a bank, it’s a continued partnership. Credit insurance allows businesses to protect themselves from non-payment, as well as drive growth and effectively manage risk. 

The cost of trade credit insurance is generally cheaper than a letter of credit and can often pay for itself with the additional sales that are generated from offering more favorable payment terms. You can incorporate the cost of credit insurance into the cost of their goods. 

Simply increasing a product cost by 0.10% can be enough to ensure protection while the cost remains neutral for the buyers. The increased sales volume from open terms as opposed to letters of credit typically offsets the small increase in the margin.

Other Alternatives to Letters of Credit

Aside from trade credit insurance, there are other alternatives to a letter of credit. Those include:

• Purchase order financing: Purchase order financing provides you cash up front to complete a purchase order. Under this agreement, a financing company pays your supplier for goods you need to fulfill a purchase order. The finance company collects payment from your customer who initiated the purchase order. The finance company then pays you, minus their fee. When using purchase order financing, you risk alerting your client to your cash flow issue.
• Invoice factoring: Factoring insurance for receivables is an agreement with a third-party company to purchase accounts receivables at a reduced amount of the face value of the invoices. The factor provides a cash advance ranging from 70% to 90% of the invoice’s value. When the invoice is collected, the factor returns the balance of the invoice minus their fee. Invoice factoring may not protect against non-payment, depending upon contract details.
• Standby letter of credit: While a commercial letter of credit is used for just one transaction, standby letter of credit insurance is used for multiple transactions. Letters of credit can be tedious and time consuming to create, and they tie up working capital.