What Is a Letter of Credit (LC)?
If you’re involved in international trade, you’ve likely heard the question—what is a Letter of Credit? It’s one of the most important tools in global business that helps both buyers and sellers feel secure. A Letter of Credit, or LC, is a financial document issued by a bank that guarantees payment to the seller, as long as certain conditions are met. It’s like a promise from a bank that says, “You’ll get paid, don’t worry.”
Understanding a Letter of Credit is crucial if you want to reduce risk in global transactions. It provides protection, trust, and structure—especially when working with new suppliers or customers overseas.
Why Are Letters of Credit Important?
Doing business across countries comes with uncertainty. What if the buyer doesn’t pay? What if the seller doesn’t ship? This is where a Letter of Credit steps in. It builds confidence for both sides, offering peace of mind and financial safety.
In simpler terms, a Letter of Credit makes sure the seller gets their money and the buyer gets their goods—as long as all the agreed documents are correctly submitted.
Here’s what makes LCs important in international trade:
- They minimize payment risk
- They act as a legal guarantee
- They help build trust with new business partners
- They support smooth trade even across unfamiliar territories
So, How Does a Letter of Credit Work?
Let’s say you’re a business in India exporting machinery to a company in Germany. You’ve never worked with them before. You’re unsure if they’ll pay after receiving the goods. The buyer feels the same—what if you don’t deliver?
The solution? A Letter of Credit.
Here’s the basic process:
- The buyer applies for an LC from their bank.
- The bank issues the LC and sends it to your bank (the seller’s bank).
- You ship the goods and submit the required documents (invoice, bill of lading, etc.).
- The bank checks the documents. If everything matches, you get paid.
- The buyer’s bank then recovers the payment from them.
In this process, the bank acts as a trusted middleman. That’s the power of knowing exactly what a Letter of Credit—it adds a secure layer to every international deal.
Types of Letters of Credit You Should Know
There isn’t just one type of LC. Depending on the trade situation, banks can issue different forms of Letters of Credit. Here are the common ones:
1. Irrevocable Letter of Credit
- Cannot be changed without agreement from all parties.
- Most commonly used and safest.
2. Revocable Letter of Credit
- Can be changed or canceled by the buyer’s bank without notice.
- Rarely used due to risk.
3. Confirmed Letter of Credit
- A second bank (usually the seller’s bank) confirms the LC.
- Offers extra security if the buyer’s country is unstable.
4. Sight LC
- Payment is made as soon as all documents are verified.
5. Usance LC (Deferred Payment LC)
- Payment is delayed by an agreed period (e.g., 30, 60, 90 days).
Understanding these types helps you choose what suits your transaction best—and answers deeper questions around what is a Letter of Credit in real practice.
Key Benefits of Using a Letter of Credit
Here’s why businesses choose LCs in global trade:
1. Security for Both Parties
The buyer pays only when the goods are shipped as agreed, and the seller gets paid once they fulfill the conditions.
2. Legal Clarity
Everything is documented. So if disputes arise, the LC becomes legal proof of the transaction terms.
3. Easier Access to Financing
Banks often offer loans against Letters of Credit, improving cash flow for exporters.
4. Trade Without Fear
Even if the buyer or seller is in a high-risk country, trade continues safely with the LC in place.
These benefits make it clear why learning what is a Letter of Credit can directly help your business grow with less stress.
What Are the Risks or Downsides?
Even though LCs are secure, they come with some practical challenges:
- Costly bank fees for issuance, confirmation, and handling
- Strict document requirements—a single mistake may delay payment
- Time-consuming process compared to other payment methods
But with proper planning and clear communication, these issues can be easily managed.
Real-World Example: Using LC in Textile Export
Imagine a textile company in India exporting garments to a retailer in France. Both parties are new to each other. The French buyer requests a shipment worth ₹25 lakhs.
To avoid risk, they agree to use a Letter of Credit.
- The buyer gets the LC issued through their bank
- The exporter ships the goods and submits all documents
- The bank verifies everything and pays the exporter
- Everyone wins, and the trade is completed smoothly
This real example shows just how helpful it is to understand what is a Letter of Credit—especially in industries like textiles, electronics, machinery, and food exports.
Best Practices for Using Letters of Credit
Want to make the most out of your LC? Follow these simple tips:
- Double-check document requirements before shipping
- Use professional help to avoid errors
- Choose a reliable bank with international trade experience
- Communicate clearly with the buyer to avoid last-minute changes
- Always keep copies of all documents submitted
Conclusion: Why You Should Understand What Is a Letter of Credit
So, what is a Letter of Credit in simple words? It’s a bank’s promise to pay, giving both buyers and sellers a safe and trustworthy way to do business internationally.
Knowing what a Letter of Credit can help you avoid late payments, reduce trade risk, and open doors to new markets. Whether you’re an exporter looking for secure payments or a buyer wanting proof of shipment before paying, the LC brings balance and peace of mind to both sides.
In global trade, trust is everything—and a Letter of Credit helps build it