What is the Difference Between a Letter of Credit and a Line of Credit?
There is a fundamental difference between a Letter of Credit and a Line of Credit. A Letter of Credit is a financial instrument issued by a bank. A Line of Credit is a loan or credit facility offered by a bank. Whether here in Switzerland or the rest of the world, these two definitions remain the same.
Letter of Credit
A Letter of Credit is a means of payment, and we will explain four well-known instruments. A Documentary Letter of Credit and a Standby Letter of Credit are the two most popular Letters of Credit. We will also deal with a Revolving Letter of Credit and a Red Clause Letter of Credit. Letters of Credit can be Irrevocable and revocable. This will be explained below.
What is a Documentary Letter of Credit?
This is a Letter of Credit issued by a bank on behalf of their client, (the importer or buyer). The Letter of Credit is sent to another bank in favour of their client, (the exporter or seller). This instrument guarantees payment to the seller in a specific currency and specified amount. The seller will submit the required documents as laid out in the Letter of Credit to their bank. Upon receipt of the documents the bank will pay the seller. There is an agreed timeframe for these documents to be presented.
What is a Standby Letter of Credit?
This is slightly different to a Documentary Letter of Credit. This instrument is a payment of the last resort. It underpins the contract between a buyer/importer and seller/exporter. It is used when the seller feels the buyer may not be able to pay under the terms of the contract. The seller requests the buyer to instruct their bank to open a Standby Letter of Credit in their favour. If the buyer fails to pay the seller will claim against the Standby Letter of Credit.
Revolving Letter of Credit
This is the same as a Documentary Letter of Credit but allows for multiple transactions between the buyer and seller. It therefore negates the need to open a new Documentary Letter of Credit for each transaction. The expiry date will therefore be much longer than a single transaction Documentary Letter of Credit.
Red Clause Letter of Credit
Again, this works in the same way as a Documentary Letter of Credit. However, it provides for a loan or advance to the seller/exporter. This will give the seller working capital to help produce the goods for export. This is often referred to as pre-shipment finance. When the seller is paid the loan/advance is deducted from the payment.
This type of Letter of Credit tends to be more expensive than a standard Documentary Letter of Credit. The buyer will request the seller to indemnify them against any loss. The seller may offer the buyer a discount if granted a Red Clause Letter of Credit. The buyer will have carried out full due diligence on the seller, especially if they are unknown to them.
Irrevocable and Revocable Letters of Credit
In today’s financial markets Revocable Letters of Credit are rarely if at all used. Revocable means the issuing bank can at any time cancel the letter of credit.
An Irrevocable Letter of Credit cannot be cancelled. It can only be cancelled, or the contents changed by the bank if all parties agree.
Line of Credit
A line of credit is a loan from a bank though it differs from a straight loan. The borrower will be granted a credit limit. They will be expected to make principal and interest repayments on specific dates. However, unlike a straight loan, the borrower can reborrow up to their credit limit.
A straight loan is usually for one specific purpose. A line of credit can cover a multitude of borrowings. Day to day company expenses including salary. Purchase of heavy equipment. Raw materials for buildings or for making products. This way the lender can ensure the borrowings are going in the right places.
A line of credit often includes borrowings to finance letters of credit. The borrower may be importing from overseas as an integral part of their business plan. The lender therefore will agree to finance their imports as part of a line of credit.