A borrower requires an official document that can give proof that the borrower will be able to repay the debt to the lender. A borrower can use either letter of credit or bank guarantee as these both promises from a financial institution and ensures that the debtor will repay his debt no matter what his/her financial circumstances.
There are significant differences between both of them. But both assure that in case the debtor fails to repay his/her debt, the financial institution will intervene to deal with the situation.
These financial documents (promises) provide financial backing and minimizes the risk factors and boost transaction to proceed. These are usually requested by the other party involved in the transaction so curb the chances of its loss.
However, both works in a quite different way and in different situations. The letter of credit is especially needed in international transactions because of the distance involved in it, difficulty for parties to meet each other, and the different laws followed by different countries.
On the other hand, bank guarantees are used in infrastructure projects and real estate contracts.
What is a letter of credit?
A letter of credit is a formal financial document and sometimes also referred to as documentary credit. It serves the purpose of a promissory note issued from a financial institution such as a credit union or a bank.
It ensures that a buyer will pay to the seller and a borrower will pay back to a lender on time and for the full amount.
According to a letter of credit, the bank has full authority to recover the balance payment if a debtor fails to pay it on time. A letter of credit signifies a responsibility taken on by a bank to make a payment once certain conditions are met.
The bank will transfer the funds when only terms mention in the letter of credit are confirmed and completed.
According to this letter, the payment to the seller will be made as long as services performed as promised. For example, a U.K wholesaler gets an order from a new client in the U.S. As the wholesaler has no way to know that whether this client is genuine or not and will he fulfill his payment obligation or not. In these circumstances, the wholesaler can request for a letter of credit for purchasing contract to curb his chances of risk.
The purchaser can apply in the bank where he already has his funds or a line of credit. The payment will be held by the bank on behalf of the buyer until it gets a confirmation that the goods as ordered has been shipped.
The payment will be paid to the wholesaler once it has been made sure that all terms of the contract have been met completely such as delivery has been made on time, the number of goods was same as ordered, and the goods are not damaged.
In simple words, a line of credit is a bank’s credit on behalf of its clients, which ensures that payment will be made as promised and also on time.
A letter of credit performs various functions such as
- Exclusion of credit when the bank has a respectable reputation.
- It provides safety to the buyer, who wants to pay only when certain conditions mentioned in the letter of credit are fulfilled.
- It reduces uncertainty. Because merchant is well-aware of the conditions that he is bound to fulfill to receive the full payment.
There are various types of letter of credit
- Usance Letter of credit.
- Sight Letter of Credit.
- Irrevocable Letter of Credit.
- Revolving Letter of Credit.
- Confirmed Letter of credit
- Standby Letter of Credit and so on.
What is a Bank Guarantee?
The bank guarantee has more substantial pledged responsibility for banks as compared to the letters of credit. A bank guarantee similar to a letter of credit guarantees a certain amount of money only when the opposite party fails to fulfill the postulated obligations mentioned under the contract.
A bank guarantee plays an important role to save both participant parties in the contractual agreement from any kind of credit risk. For example, a construction company wants to buy cement from a cement supplier to build a mall.
For this, they enter into a new contract. In this case, both parties are required to issue bank guarantees to make sure their financial capabilities and bona fides.
If the cement company fails to deliver order amount of cement with specified quality within a specified time, the construction company has right to notify the bank and bank will pay to the construction company as it was mentioned in the bank guarantee.
The bank guarantee is of two types.
- Performance Guarantee
- Financial Guarantee
The Key differences between Letter of credit and Bank guarantee
| Letter of Credit | Bank Guarantee |
|---|---|
| A letter of credit is a financial document offered by a financial institution such as bank to assure payment. That means it give surety to seller to receive full payment only after all stated condition in letter of credit are met without any exception. | A bank guarantee is provided by bank to the recipient on the behalf of the claimant to receive payment in case claimant defaults in payment. |
| The liability of letter of credit is primary. | The liability of bank guarantee is secondary. |
| The risk involved is low for the merchant and high for the bank. | There is less risk for bank and more risk for merchant. |
| There can be 5 or more parties can be involved in letter of credit. | There can be only three parties can involve in bank guarantee. |
| Letter of credit does not wait for claimant to become default and beneficiary to raise understanding. | Bank guarantee becomes practicing only when claimant become default in making payment. |
| The payment is made only when all condition mentioned in the letter of credit are fulfilled. | The payment is made when any one of the conditions mentioned in the bank guarantee is not fulfilled. |
| Letter of credit is important for all international transactions. | The bank guarantee is important for all government contracts. |
Special consideration about “letter of credit” and “Bank guarantee.”
Both letter of credit and bank guarantee minimizes the risk in business deal or agreement. Usually, parties involved are happy to the transaction because their liabilities reduce when bank guarantee and letter of credit is active.
These agreements are predominantly useful and important; otherwise, transaction could turn out be risky transaction like international trades or certain real estate transactions.
Banks systematically mention all interests of clients in these documents. Bank ensures that the applicant is creditworthy and suitable for the transaction and has rational risks, and a monetary limit is also mentioned in the agreement.
The bank then obliged with no exceeding limit. In this way, a bank offers a definite threshold of risk.
Conclusion
A letter of credit is popular when it comes to international transactions. However, these days letter of credit is also becoming popular in domestic transactions. No matter transaction involves international parties, or it involves national parties, the buyer is always obliged to pay for the purchase made by him, which facilitates by the letter of credit at minimum risk for both parties involved.
On the other hand, a bank guarantee is useful to fulfill various obligations involved in the business. In this case, the bank plays the role of guarantor and provides a guarantee to the beneficiary, which is important to fulfill the business requirements.
