Definition: A letter of credit is a commitment issued by a bank on behalf of one of its customers to guarantee a payment that must be made to a third party as the result of an import/export transaction. In other words, the issuing bank will guarantee the payment to the exporter.
What Does Letter of Credit Mean?
What is the definition of letter of credit? Letters of credit are financial instruments used by companies to facilitate import/export transactions. These letters are documents issued by the importer’s bank (issuing bank) to guarantee the payment of the goods being imported. The letter is issued and sent to the exporter’s bank (accepting bank) to constitute an obligation to pay for the goods as long as a set of pre-established conditions are met. These conditions are usually in the form of documents to be presented such as commercial invoices, tax forms, certificates of origin, among others. The payment must be released by the issuing bank in full on the previously agreed date, if all these conditions are met.
Let’s look at an example.
Example
High-end Motorcycles LLC is a company that sells imported motorcycles in the U.S. As part of their regular business activities they buy motorcycles from a company in Italy called Vecchia Motorcycles Co. High-end wants to close a deal to buy a 1,000 motorcycles from Vecchia. How can they guarantee that both parties get their side of the deal, goods for one side, and on-time payment for the other side?
As we previously wrote, a letter of credit constitutes a guarantee for the exporter that payment will be issued on time for the goods being dispatched to the buyer. In this situation, a letter of credit will ensure both parties that the transaction will be conducted and concluded properly and payment will be surely released once the pre-negotiated conditions are met.
Summary Definition
Define Letters of Credit: Letter of credit means a financial document that one bank sends to another on the behalf of its depositor to ensure payment will be made if the transaction is executed.
