Definition

• As defined by businessdictionary.com and loanuniverse.com, a letter of credit is a formal document issued by a bank. A letter of credit guarantees that the bank will cover a transaction on behalf of the buyer.
  
  

Types and Purpose

• The purpose of a letter of credit is disguised within the letter of credit type. Letters of credit may be either commercial or standby. According to the Credit Research Foundation and teachmefinance.com, a commercial letter of credit finances a transaction with the bank making the payment for the buyer--the purpose here is to actually complete the transaction. A standby letter of credit, by contrast, pays only if the buyer can't. In this way, the purpose of a standby letter of credit really is to strengthen the trust between a buyer and seller.
  
  

Disadvantages

• A letter of credit won't always protect a buyer against poor-quality services, according to TD Securities. Furthermore, TD Securities and key.com claim that a buyer has to have a line of credit with his bank before he can request a letter of credit. The seller also has to prepare documentation according to the stipulations of the letter of credit. Finally, banks issue a letter of credit against the line of credit a person has, which means that the buyer will tie up that credit and be unable to use it for anything else.
  
  

Advantages

• Letters of credit have the obvious advantage of ensuring payment. Additionally, because the seller deals with the bank's credit, the buyer often is willing to offer better contract terms, such as lower purchase prices. From the seller's perspective, letters of credit are advantageous because they permit the conclusion of transactions that otherwise might not be financially feasible without directly taking out loans. Because the bank backs the buyer, the buyer can appear trustworthy to sellers who would not sell based only on the buyer's credit.
  
  

Process

• A buyer must go through a standard process for the letter of credit to fulfill its purpose. Usually the buyer has to make an agreement with a seller and submit an application to his bank. The bank then forwards the credit to the buyer's branch, authenticates it, and forwards it to the seller's bank. Once the seller prepares the documents related to the letter of credit and ships the goods involved, the buyer's bank reviews the documents, debits the buyer's account and forwards the seller's documentation to the buyer.