Letters of Credit are contingent loans underwritten by a bank for qualified applicants, to honor demands for payment to a vendor for merchandise shipped or services performed.
Letters of Credit are often required when dealing with new vendors where there isn’t an established relationship or sometimes with vendors in different countries. The bank substitutes its credit for yours for purpose of trade.
There are two types of Letters of Credit.
1) A Commercial Letter of Credit serves as a direct payment for a transaction and is a contractual agreement to pay the vendor. When a bank establishes the Letter of Credit it is committed to honor the payment when requested and when the terms between the two parties have been met.
2) A Standby Letter of Credit, also known as a Performance Letter of Credit is only drawn upon if a specified event is not performed according to the agreement established between the two parties. For example, you may be required to provide a Letter of Credit when leasing warehouse space. If you fail to pay your rent, the landlord would have the right to draw on the Letter of Credit and get paid. The parties involved don’t expect to draw on the issuing bank’s Letter of Credit unless the primary source of payment fails.
