A Beginner’s Guide to Letters of Credit in International Trade
When companies cross borders to buy or sell, there’s inherent risk. Will payment happen? Will goods arrive? That’s where tools like Letters of Credit (LCs) come in.
What is a Letter of Credit?
A financial instrument where a buyer’s bank guarantees payment to the seller once the agreed conditions are met (shipping documents, inspection, etc.).
Why do Letters of Credit matter?
They build trust between buyer and seller, reduce payment risk, and can open markets for exporters who might not have prior relationships with buyers.
Types of Letters of Credit include:
• Confirmed vs. Unconfirmed
• Revocable vs. Irrevocable
• Standby LCs
Typical Use Case:
An exporter in country A ships goods; they present required documents to their bank, which verifies conditions; upon verification, the buyer’s bank pays through the LC.
Letters of Credit remain a backbone of international trade, especially in early or uncertain relationships when full trust isn't yet built.
What Is a Letter of Credit?
A letter of credit (LC) is a financial document issued by a bank that guarantees payment to a seller on behalf of a buyer, provided the seller meets specified terms and conditions outlined in the LC. In international trade, letters of credit serve as one of the most trusted payment mechanisms because they shift the credit risk from the buyer to the issuing bank. This means that even if the buyer faces financial difficulties, the seller is protected as long as they comply with the documentary requirements.
Letters of credit are governed by the Uniform Customs and Practice for Documentary Credits (UCP 600), published by the International Chamber of Commerce (ICC). These internationally recognized rules standardize how LCs are issued, amended, and honored across borders, providing a consistent framework that banks and businesses worldwide can rely on. For companies new to international trade, understanding letters of credit is essential for managing payment risk and building trust with overseas trading partners.
How Does a Letter of Credit Work?
The letter of credit process involves several parties and steps. First, the buyer (also called the applicant) and seller (the beneficiary) agree on a sale and that payment will be made via letter of credit. The buyer then applies to their bank (the issuing bank) to open an LC in favor of the seller. The issuing bank evaluates the buyer's creditworthiness and, if approved, issues the LC and sends it to a bank in the seller's country (the advising bank or confirming bank).
Once the seller receives the LC, they review the terms and ship the goods. After shipment, the seller gathers the required documents — typically including a commercial invoice, bill of lading, packing list, certificate of origin, and insurance certificate — and presents them to the advising bank. The bank examines the documents to ensure they comply with the LC terms. If everything is in order, the advising bank forwards the documents to the issuing bank, which then releases payment to the seller. The buyer receives the shipping documents and uses them to claim the goods upon arrival.
This structured process protects both parties: the seller knows they will be paid if they present compliant documents, and the buyer knows that payment will only be released when the goods have been shipped according to the agreed terms. The banks serve as neutral intermediaries, adding a layer of security and trust to the transaction that open account or advance payment terms cannot match.
Types of Letters of Credit
Irrevocable Letter of Credit
An irrevocable letter of credit cannot be amended or canceled without the agreement of all parties involved — the buyer, seller, and issuing bank. This is the most common type used in international trade because it provides the strongest guarantee to the seller. Under UCP 600, all letters of credit are irrevocable by default unless explicitly stated otherwise.
Confirmed Letter of Credit
A confirmed LC adds a second bank's guarantee (the confirming bank, usually in the seller's country) on top of the issuing bank's promise to pay. This is particularly valuable when the seller is concerned about the creditworthiness of the issuing bank or the political and economic stability of the buyer's country. The confirming bank takes on the obligation to pay even if the issuing bank fails to honor its commitment.
Standby Letter of Credit
A standby LC functions more like a guarantee than a traditional payment mechanism. It is only drawn upon if the buyer fails to fulfill their payment obligations. Standby LCs are often used in ongoing business relationships where the buyer typically pays on open account terms, but the seller wants a safety net in case of default. They are also commonly used in construction contracts and service agreements.
Revolving Letter of Credit
A revolving LC is designed for buyers and sellers who engage in regular, repeated transactions. Instead of opening a new LC for each shipment, the revolving LC automatically renews after each drawing, up to a specified limit and time period. This reduces administrative costs and banking fees for both parties while maintaining payment security throughout the trading relationship.
Transferable Letter of Credit
A transferable LC allows the original beneficiary (typically a middleman or trading company) to transfer all or part of the credit to one or more secondary beneficiaries, usually the actual suppliers of goods. This type is commonly used by trading companies that source products from manufacturers but sell to end buyers. It enables the middleman to use the buyer's credit to pay their own suppliers without tying up their own capital.
Key Documents Required for a Letter of Credit
Document compliance is the cornerstone of the letter of credit process. Even minor discrepancies can result in delayed or rejected payment. The specific documents required vary by transaction, but the most commonly requested include a commercial invoice detailing the goods, quantities, and prices; a bill of lading or airway bill proving that goods have been shipped; a packing list describing how goods are packed; a certificate of origin verifying where the goods were manufactured; and an insurance certificate covering the goods during transit.
Studies by the ICC estimate that approximately 60-70% of initial document presentations under letters of credit contain discrepancies. Common issues include misspelled names, incorrect quantities, late shipment dates, missing endorsements, and inconsistencies between documents. Working with an experienced trade finance advisor can help exporters prepare compliant documentation and avoid costly delays. At Impello Global, our advisory team helps clients navigate document requirements and minimize discrepancy risks.
How Much Does a Letter of Credit Cost?
Letters of credit involve several fees charged by the banks involved. The issuing bank typically charges the buyer an issuance fee of 0.75% to 1.5% of the LC value, along with an amendment fee if changes are needed after issuance. The advising bank charges the seller a smaller advising fee, usually a flat rate or a percentage of the LC value. If the seller requests confirmation, the confirming bank charges a confirmation fee that can range from 0.1% to 2% or more, depending on the country risk and creditworthiness of the issuing bank.
Additional costs may include negotiation fees, document examination fees, courier charges, and SWIFT messaging fees. While these costs add up, they are generally considered a worthwhile investment for securing payment in international trade, especially when dealing with new trading partners, high-value shipments, or transactions involving higher-risk markets. Many businesses factor LC costs into their pricing when quoting international deals.
Letters of Credit vs. Other International Payment Methods
International trade offers several payment methods, each with different levels of risk for buyers and sellers. Advance payment (cash in advance) is the safest for sellers but riskiest for buyers, as they pay before receiving goods. Open account terms are the opposite — the buyer receives goods before payment is due, which favors the buyer but exposes the seller to non-payment risk. Documentary collections offer a middle ground, where banks handle document exchange but do not guarantee payment.
Letters of credit strike the best balance for both parties by providing bank-guaranteed payment security. They are especially appropriate for first-time transactions with unknown buyers, large-value orders, trades involving politically or economically unstable regions, and transactions where the buyer requires extended payment terms. For ongoing relationships with established buyers, companies may transition from LCs to open account terms backed by trade credit insurance, which offers similar payment protection at a lower cost. Impello Global's advisory team can help you determine the optimal payment structure for each trading relationship.
Common Mistakes to Avoid with Letters of Credit
One of the most frequent mistakes exporters make is failing to review the LC terms carefully before shipping goods. Every letter of credit contains specific conditions regarding shipping dates, ports of loading and discharge, document requirements, and goods descriptions. Shipping before thoroughly understanding these requirements often leads to discrepant presentations and payment delays. Always compare the LC terms against your sales contract and raise any concerns with the buyer immediately.
Another common error is missing the document presentation deadline. Under UCP 600, documents must be presented within 21 days of the shipment date (or by the LC expiry date, whichever comes first) unless the LC specifies a different timeframe. Late presentations are a discrepancy that banks will flag, potentially resulting in refused payment. Exporters should also avoid inconsistencies between documents — for example, the goods description on the commercial invoice must match the LC exactly, even down to spelling and punctuation.
Frequently Asked Questions About Letters of Credit
How long does it take to open a letter of credit?
Opening a letter of credit typically takes 2 to 10 business days, depending on the issuing bank's processing time, the complexity of the transaction, and whether the buyer has an existing credit facility with the bank. If the buyer needs to establish a new credit line, the process may take longer as the bank conducts its due diligence and credit assessment.
Can a letter of credit be amended after it is issued?
Yes, an irrevocable LC can be amended, but only with the consent of all parties — the buyer, seller, issuing bank, and confirming bank (if applicable). Common amendments include extending the shipment date, changing the goods description, increasing the LC amount, or modifying document requirements. Each amendment incurs additional bank fees, so it is best to finalize all terms before the LC is issued.
What happens if documents are discrepant?
If the presented documents contain discrepancies, the issuing bank will notify the presenter and may refuse payment. The seller then has several options: correct the documents and re-present them (if time permits), request the buyer to authorize the bank to accept the documents despite discrepancies, or negotiate directly with the buyer. Working with a knowledgeable trade finance advisor before presentation significantly reduces discrepancy risk.
When should I use a letter of credit versus trade credit insurance?
Letters of credit are ideal for one-off or early-stage trading relationships where the buyer and seller have not yet established trust. They provide transaction-by-transaction security but involve higher per-transaction costs and more administrative effort. Trade credit insurance is better suited for ongoing relationships with multiple buyers, as it covers your entire receivables portfolio at a fraction of the cost of individual LCs. Many growing exporters start with letters of credit and transition to trade credit insurance as their trade volumes increase. Impello Global can help you evaluate both options and design the right risk management strategy for your business.
Get Expert Guidance on Letters of Credit and Trade Finance
Navigating letters of credit and international payment methods can be complex, but you do not have to do it alone. Impello Global's advisory team specializes in helping U.S. exporters structure secure, cost-effective trade finance solutions — from letters of credit and documentary collections to trade credit insurance and EXIM Bank programs. As an EXIM Bank Platinum Broker, we have the expertise and carrier relationships to protect your international receivables and support your growth in global markets. Contact us today for a free consultation and learn how we can help you trade with confidence.