In a sale, a buyer wants to receive goods, and the seller wants to receive payment for those goods. It's as simple as that — but the process can go wrong. A letter of credit and a line of credit are both instruments used between buyers and sellers to make sure this commercial transaction goes smoothly.
Letter of Credit
A letter of credit is a written assurance, or commitment, that the bank of a buyer or importer gives to the bank of a seller or exporter. The buyer's bank is referred to as the issuing bank, while the seller's bank is referred to as the accepting bank. The purpose of a letter of credit is to facilitate a transaction between the buyer and the seller by providing assurance to the seller that he will receive payment for the goods that are sold. It's a guarantee that the seller will receive a payment of a specific amount in a specific currency as long as the seller adheres to the terms and conditions that the buyer and seller agree on.
Line of Credit
A line of credit is different from a letter of credit. A line of credit permits the buyer to purchase items now but pay for them later. The line of credit is extended to the buyer based upon specific payment terms, such as how long the buyer has before payment must be made and the payoff amount the buyer must remit to the seller. The line of credit also specifies the amount of product the buyer is able to receive on credit at any given time. A line of credit represents the total amount of unpaid invoices, orders confirmed but not yet shipped and goods in transit. Letters of credit and lines of credit are generally used in international commerce.
Here's how they're connected: a seller issues a line of credit to a buyer based upon the buyer's creditworthiness. If the seller doesn't consider the buyer credit-worthy and is unwilling to extend credit to the buyer, the seller will request that the buyer provide a letter of credit from the buyer's bank instead. A letter of credit is a formal trade instrument. This means the letter of credit from the bank substitutes the bank's creditworthiness for the creditworthiness of the buyer. The seller is assured he will receive payment and is therefore willing to sell to the buyer.
Also, keep this in mind: the buyer who requests a letter of credit from the bank is called an applicant, or account party. The seller or exporter receiving the letter of credit is called a beneficiary. Before the bank issues a letter of credit to the beneficiary, the applicant must pay the cost of the goods upfront to the bank, or negotiate a loan or other business credit terms from the issuing bank. The applicant (buyer) must do one or the other before the bank will provide a letter of credit on his behalf.