There are various types of letters of credit available to help sellers and buyers negotiate a business deal. Letters of credit are considered standby, documentary or special letters of credit. Within these classifications, several types of letters of credit exist, such as the revocable, irrevocable and revolving letters of credit.
Letters of credit are drafted to help reassure the seller that the buyer will make payment on a shipment or purchase. Commonly used in international trade, the various types of letters of credit are prepared after an agreement has been reached concerning the terms of the business deal. The various types of letters of credit all have specific caveats for use.
Initiating the process to issue a letter of credit begins with the buyer requesting a letter of credit from his bank, also known as the issuing bank, to satisfy the terms of the deal and guarantee payment to the seller. The issuing bank will then send the letter of credit to the seller’s bank, known as the advising bank if it is simply assisting in the processing of the payment or the confirming bank if it also is guaranteeing payment to the seller. Once agreed to, the business transaction can take place and payment can be made to the seller once the transaction is completed.
Standby letters of credit are more commonly used on a domestic level. They only come into force if the buyer fails to pay the seller on his own. This type of letter of credit can help new businesses or unknown businesses develop a relationship with a supplier. In the event the buyer fails to pay, the seller has the ability to cash in the standby letter of credit at the issuing bank.
International trade often involves the use of specific types of letters of credit, referred to as documentary letters of credit. Two classifications exist for documentary letters of credit: revocable and irrevocable. Revocable letters of credit allow a buyer to modify or cancel the letter of credit without advising the seller. These are rarely used, as a seller generally won’t agree to those terms. Irrevocable letters of credit, on the other hand, cannot be changed or modified by the buyer unless the seller agrees to the change.
Several types of letters of credits are considered special letters of credit. The revolving letter of credit allows a buyer access to a line of credit over a specific time period. This can be limited to the number of times a buyer can borrow and usually requires a buyer to pay down the letter of credit before accessing another round of credit. Other types of letters of credit include the transferable, deferred payment and red clause letter of credit.
