A letter of credit is one of the most widely used payment tools in international trade. It helps reduce payment risk by placing a bank between the buyer and seller and requiring specific shipping and trade documents before payment is made.
Letter of credit definition
A letter of credit is a bank-issued commitment to pay a seller on behalf of a buyer, provided the seller presents the required documents and meets the terms of the credit. In simple terms, a letter of credit helps protect both sides of an international transaction: the seller gains more confidence of payment, and the buyer knows payment is tied to agreed shipping and trade documents.
What does a letter of credit mean in international trade?
In international trade, a letter of credit is a documentary payment method used when the buyer and seller want more security than open-account terms usually provide. Instead of relying only on the buyer’s promise to pay, the seller relies on the issuing bank’s commitment, as long as the documents presented comply with the letter of credit terms.
That is why letters of credit are especially common in cross-border trade where the parties may be in different countries, subject to different legal systems, or working together for the first time.
How a letter of credit works
A letter of credit works by connecting payment to document presentation. The buyer arranges for the bank to issue the credit, the seller ships the goods, and the bank reviews the required documents before releasing payment under the agreed terms.
- Buyer and seller agree to use a letter of credit: the payment method is written into the sales contract.
- The buyer’s bank issues the credit: the issuing bank creates the letter of credit in favor of the seller.
- The seller ships the goods: the cargo moves according to the agreed shipment terms.
- Required documents are submitted: the seller presents the documents specified in the credit.
- The bank reviews compliance: payment is made if the documents meet the terms and conditions of the credit.
Why use a letter of credit?
Buyers and sellers use letters of credit to reduce risk in international transactions. The seller wants stronger payment assurance, while the buyer wants to know that payment will only be made when the required documents are presented.
- Reduces payment risk for the seller
- Adds structure to international trade transactions
- Ties payment to document compliance
- Helps build trust between unfamiliar trading partners
- Supports higher-value or more complex cross-border deals
For businesses coordinating documentation-heavy imports, Dedola’s global logistics services can help connect freight execution with the paperwork and timing that international shipments depend on.
Common documents required under a letter of credit
A letter of credit is often called a documentary trade instrument because payment depends on document presentation. The exact document set varies by transaction, but these are among the most common requirements:
- Bill of lading: evidence of shipment and carriage
- Commercial invoice: details of the goods sold and their value
- Packing list: description of shipment contents, cartons, weights, and dimensions
- Certificate of origin: identifies where the goods were produced
- Insurance certificate: if insurance is required under the trade terms
- Inspection or compliance documents: when required by the transaction or destination country
Who is involved in a letter of credit?
A letter of credit usually involves several parties, each with a specific role in the trade and payment process.
- Applicant: the buyer requesting the letter of credit
- Beneficiary: the seller who will receive payment if the terms are met
- Issuing bank: the bank that issues the letter of credit on behalf of the buyer
- Advising bank: the bank that authenticates and forwards the credit to the seller
- Confirming bank: if used, a bank that adds its own payment undertaking
Types of letters of credit
The most common trade-finance discussions include several letter of credit types, depending on how the transaction is structured and how much protection the parties want.
- Commercial letter of credit: used as the main payment mechanism for a trade transaction
- Irrevocable letter of credit: cannot be changed without agreement from the relevant parties
- Confirmed letter of credit: includes an additional bank undertaking beyond the issuing bank
- Standby letter of credit: generally used as a backup payment or performance protection tool
Letter of credit vs open account
The main difference between a letter of credit and open-account trade terms is the level of bank involvement and payment security. Under open-account terms, the seller ships and waits for the buyer to pay later. Under a letter of credit, the bank’s documentary commitment adds structure and reduces uncertainty for the seller.
This can be especially important when the shipment is moving internationally by ocean freight or air freight, where document accuracy and timing can directly affect release, payment, and delivery.
Why a letter of credit matters in global logistics
A letter of credit matters because international trade is not just about moving cargo. It is also about controlling payment risk, document flow, and transaction timing. When shipping documents, bank terms, and cargo movement all need to align, a letter of credit can provide a more structured path from sale to shipment to payment.
Letter of credit FAQ
What is a letter of credit in simple terms?
A letter of credit is a bank promise to pay the seller for a trade transaction if the seller provides the documents required by the credit.
Why is a letter of credit used?
It is used to reduce payment risk in international trade by making payment dependent on documentary compliance rather than on trust alone between buyer and seller.
What documents are usually required for a letter of credit?
Common documents include a bill of lading, commercial invoice, packing list, certificate of origin, and other shipment or compliance documents specified in the credit.
Is a letter of credit the same as a bank guarantee?
Not exactly. Both reduce risk, but a letter of credit is typically a documentary trade-payment instrument, while a bank guarantee is often used more as a fallback assurance if one party fails to meet its obligation.
