What Is a Letter of Credit and When Do You Need One

What Is a Letter of Credit and When Do You Need One

What a Letter of Credit Really Is

A letter of credit, sometimes called a documentary credit or an LC, is one of the oldest tools in international trade. It exists because a buyer and a seller in different countries rarely trust each other completely at the same time. The buyer does not want to send money and receive nothing. The seller does not want to ship goods and wait months for payment.

A letter of credit puts a bank in the middle. The bank agrees to pay the seller, on the buyer's behalf, as long as the seller hands over a specific set of documents by a specific date. The documents do the talking. If the paperwork matches the terms of the credit, the bank pays. If it does not match, the bank does not pay.

That is the whole idea in one sentence. The bank is not checking whether the goods are good. It is checking whether the documents are correct. This is a detail that surprises many first time importers, and it is the reason so many LC disputes are really paperwork disputes.

The rules that govern most letters of credit are published by the International Chamber of Commerce. You can read about the current version of those rules at the ICC, which maintains the Uniform Customs and Practice for Documentary Credits. Most banks around the world work from that same rulebook, which is why an LC issued in Lagos can be honoured in Shenzhen.

How a Letter of Credit Works Step by Step

A standard import letter of credit moves through a predictable sequence. Once you understand the sequence, the fees and the delays stop being a mystery.

1. The buyer and seller agree a contract and settle on payment by letter of credit.
2. The buyer applies to their bank for the credit, and the bank asks for a deposit or collateral.
3. The buyer's bank issues the credit and sends it to a bank in the seller's country, called the advising bank.
4. The advising bank checks the credit is genuine and tells the seller it has arrived.
5. The seller ships the goods and collects the documents, usually a bill of lading, an invoice, a packing list and any inspection or insurance certificates.
6. The seller presents those documents to the advising bank before the expiry date.
7. The documents travel to the issuing bank, which checks them against the credit terms.
8. If everything matches, the issuing bank pays, and the buyer collects the documents and the goods.

The whole cycle often takes between five and fifteen working days after the goods are shipped, depending on the countries involved and how quickly documents move. Any bank in the chain can add a step if documents look inconsistent.

The Main Types of Letter of Credit

Not every credit works the same way, and picking the wrong type for your deal can create needless cost.

• Irrevocable letter of credit. The buyer cannot cancel or change it without the seller's agreement. Almost all modern credits are irrevocable, which is why sellers usually insist on this wording.
• Confirmed letter of credit. A second bank, often in the seller's country, adds its own guarantee to pay. This costs extra, but it removes the risk that the issuing bank or the issuing country cannot pay. Sellers in higher risk markets often ask for it.
• Revocable letter of credit. The buyer can amend or cancel it before payment. It offers very little protection and is rarely used today.
• Sight letter of credit. The bank pays as soon as compliant documents arrive.
• Usance or term letter of credit. The bank pays at a fixed later date, which gives the buyer time to sell the goods before settling.
• Transferable letter of credit. A middle trader can pass part of the credit to a supplier. Useful for agents and trading houses.
• Standby letter of credit. It works more like a guarantee than a payment method, and it pays only if the other side fails to perform.

For most small importers buying stock from a factory, a simple irrevocable sight credit is enough. The more complex structures exist for larger, longer or riskier deals.

When You Actually Need a Letter of Credit

A letter of credit earns its cost when the value of the order is large enough that a failed payment would genuinely hurt, and when the two sides do not yet have a working relationship.

It makes sense when:

• The order value is significant, often tens of thousands of dollars or more.
• You are buying from a new supplier in a country you have never traded with.
• Your supplier will only ship after a bank guarantee, not after a plain transfer.
• Your goods are custom made, so a failed order cannot be resold easily.
• Government tenders, shipping lines or customs authorities require a bank backed document.

It makes less sense when:

• The order is small, because the bank fees can easily exceed the benefit.
• You have a long, proven relationship with the supplier and a steady payment history.
• The supplier accepts staged payments, for example a deposit before production and a balance before shipping.
• Speed matters more than security, for example when a production window closes in days.

This is where many importers overpay. They use a heavy instrument on a light transaction, then wonder why a simple stock order took three weeks to pay. The tool should match the risk.

What a Letter of Credit Costs

A letter of credit is one of the more expensive ways to move money, and the cost comes in several parts rather than one fee. Typically you will see an issuance fee charged as a percentage of the credit value, a confirmation fee if you confirm it, an amendment fee every time a term changes, a discrepancy fee if documents do not match, and a courier or handling charge for moving paper. On top of that, the bank usually holds a deposit or blocks part of your credit line for the life of the credit, which has a real cost for a growing business.

Rates change by bank and by country, so treat any single figure as a starting point rather than a rule. What matters is comparing the all in cost against the value of the security you gain. For a first order with an unknown supplier, that security can be worth every cent. For a repeat order with a trusted factory, it usually is not.

You can see how official institutions frame the trade off between safety and cost in the World Bank's work on payment systems and remittances at the World Bank. Cross-border payment costs have fallen sharply over the past decade, and the gap between a slow documentary route and a modern direct route has widened with them.

Where a Direct Transfer Fits Better

For most everyday supplier payments, a letter of credit is more instrument than the order needs. A deposit paid on a fast conventional rail, followed by a balance before shipping, gives you most of the protection you need at a fraction of the cost. The trick is to make the payment itself traceable and quick.

That is where a platform like DapsyPay fits. It runs on conventional transfer rails such as SEPA and ACH, so payments move fast, without the limits that often block larger bank transfers, and the recipient receives funds into a named bank account. For importers who pay several suppliers a month, that combination of speed and no limits matters more than a stack of bank documents.

If your compliance or finance team needs a documented trail, a bank transfer still gives you a clear reference, a beneficiary name and a dated payment record. You can pair that with a written contract and a pre shipment inspection to cover the same risks a letter of credit would, while keeping your working capital free instead of locked in a bank deposit.

The same logic applies beyond trade. When you are paying tuition, a hospital deposit or a property completion balance, the question is the same: how much security do you really need, and what does that security cost you in time and money. Our guides on how to transfer money abroad without fees and what a domiciliary account is and how you use one walk through the practical side of that decision.

Common Mistakes When Using Letters of Credit

Most letters of credit that go wrong do not go wrong because of fraud. They go wrong on details.

• Vague descriptions. If the credit describes goods loosely and the invoice describes them differently, the bank may treat it as a discrepancy.
• Unrealistic dates. A shipping date that leaves no room for production delays forces an amendment, and amendments cost money.
• Missing documents. If the credit calls for an inspection certificate and the seller never arranged one, payment stalls on the ship's departure date.
• Ignoring expiry rules. A credit that expires before documents can reach the bank is a credit that may never pay.
• Signing a credit you cannot read. Every line in the credit changes what the bank will accept.

The simplest defence is a checklist. Before the credit is issued, walk through the goods description, the documents, the dates and the shipment terms with your supplier line by line. Fixing a term before issuance is free. Fixing it afterwards is an amendment.

Letter of Credit vs Bank Transfer

Read the table as a guide, not a verdict. The right answer depends on how much you trust the other side and how much the order is worth to you.

Frequently Asked Questions

Conclusion

A letter of credit is a bank backed promise that pays on documents, not on trust. It is powerful, and for a large first order from a supplier you do not know, it can be the difference between a safe deal and an expensive lesson. It is also slow, paper heavy and more costly than most small orders justify.

The practical approach is to match the instrument to the risk. Use a letter of credit when the order is large and the relationship is new. Use a staged direct transfer when the order is routine and the supplier is proven. For the second case, a platform like DapsyPay keeps payments fast, removes the limits that slow large transfers, and delivers into the supplier's bank account, so your money works as hard as your trade does.

If your card keeps failing on smaller overseas payments, our guide on whether you can use your debit card abroad explains why, and for a look at how newer payment networks price a transfer, see network fees and settlement.