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How Does A Letter of Credit Work and What Is It ?
December 31, 2014 Small Business Team, Ex-Im Bank

Did you know that when exporting there are ways to secure payment from your foreign buyer so that if they do not pay you—you still get paid? A letter of credit is one method of payment that your export business can leverage to insure against foreign-buyer nonpayment.If you export goods or services, you may have your foreign buyer pay in advance of delivery. A letter of credit gives your business a high level of certainty that you will be paid for the goods or services that you export, offering one of the more secure methods of international payment.

What is a letter of credit?

A letter of credit is a legal document that transfers responsibility for collecting payment for shipped goods and services from your business to your foreign buyer’s bank. The letter of credit stipulates that if your foreign buyer is unable to pay for the goods that you exported to them, your foreign buyer's bank will pay your business instead. In other words, if your buyer has a letter of credit covering a shipment, your buyer’s bank has promised that you will receive payment for that shipment, even if the foreign buyer does not pay.

How does a letter of credit work?

  • Step 1: You and your foreign buyer agree through a contract that you will export goods or services to a buyer for a set price. You ask your buyer to obtain a letter of credit, which will guarantee that you receive payment for your exports.
  • Step 2: Your foreign buyer applies for a letter of credit through a bank, which assesses the buyer's credit risk. If the bank approves of the buyer, the bank issues a letter of credit to the buyer.
  • Step 3: In the United States, your bank evaluates the foreign buyer's letter of credit and forwards it to your business.
  • Step 4: You export the purchased goods or services to the buyer and document that you sent the goods or services to the buyer as originally agreed upon in the contract. You then submit the documents to your bank as proof that you provided the goods or services to your buyer.
  • Step 5: Your bank sends the shipping documents to your buyer's bank and waits for your buyer's bank to pay.
  • Step 6: Your buyer's bank receives the documents, removes money from the buyer's account at that bank, and sends the money to your bank.
  • Finally: Your bank receives the money from your buyer's bank and deposits the funds into your account.

What are the alternatives to a letter of credit?

A letter of credit is a useful tool for export businesses, ensuring foreign buyer payment. However, it is also burdensome and expensive for foreign buyers, making a letter of credit less than ideal when marketing the sale of certain goods and services and when competing against other businesses.

As an alternative, an exporter can either require payment up front,or offer some form of open account terms. Offering open account terms allows your business to be more flexible regarding payment for goods and services and could allow your business to “seal the deal” when competing overseas. As such, exporters are increasingly offering payment terms that are less constraining by providing more flexible credit terms on an open account basis. This includes providing credit to foreign buyers you deem to be creditworthy, allowing them to pay your business for goods and services at a later date and time than the initial point of sale.

The Export-Import Bank of the United States (Ex-Im Bank) offers a variety of products and services that complement or can substitute for a letter of credit. Export Credit Insurance insures against nonpayment for U.S. made products and services sold overseas, while the Working Capital Guarantee program can provide your business access to the pre-export capital required to capture sales.

No transaction is too small to be financed with Ex-Im Bank support. Learn more by downloading the U.S. Department of Commerce’s Trade Finance Guide below, or call our National Contact Center at +1-800-565-EXIM(3946) to find out more and get started today!

Trade Finance Guide