When someone trades inside or outside India, the sellers often require a guarantee that they will get the correct payment from the buyer in a stipulated time period. Letter of credit and bank guarantee are two such guarantees which a buyer can get issued from bank and give to the seller
So they both guarantee on your behalf that the payment will get received to seller and he can provide his services to buyer. They eliminate the risk for exporter or seller.
Letter of Credit
- A letter of credit is a letter issued by bank which guarantees seller’s payment on time and in correct amount up to the time the services will be delivered to the buyer.
- So, it ensures that the transaction of money will go as planned by the bank.
- Example: You purchase some material from a seller and that material is to come on continuous basis for a month, you can get issue a letter of credit from bank and give to the seller which will ensure that the seller will receive his payments on regular basis. So the seller will believe more on the letter of credit issued than you for the payments.
- It can be used when someone imports goods from another country. In this case also a letter of credit can be given to seller.
- Most of the time the seller himself asks for a letter of credit from the buyer.
- It eliminates the financial risk because payment is to come from a bank.
- Bank guarantee also has the functions as are of letter of credit with a small distinction.
- Unlike in letter of credit, in a bank guarantee the payment is done only when the buyer is not able to pay the required amount of money to the seller.
- Example: Same example can be taken; you buy material or import something to country, you can give a bank guarantee letter to exporter that will say that if you do not provide the payment, then bank will provide that on your behalf.
So the difference between the two is that if you give letter of credit to seller, that will ensure that bank will pay on your behalf up to the day the services are being provided to you by the seller and if you give bank guarantee to seller, that will ensure that bank will pay on your behalf if you are not able to pay the amount.
Banks can apply charges to issue both letter of credit and bank guarantee.