How a letter of credit works
In short
A letter of credit (L/C) is a written undertaking by a bank to pay the seller once the seller presents documents that exactly match the agreed terms. It replaces trust between two companies with trust in their banks, which makes it a common tool for larger or cross-border deals between new partners. This is general guidance, not legal or financial advice — confirm the mechanics and costs with your bank.
When two companies do not yet trust each other with a large order, a letter of credit lets a bank stand in the middle. Instead of the buyer and seller relying on each other, each relies on a bank, and payment turns on documents rather than promises. Here is how it works in plain terms. This is general guidance, not legal or financial advice; the exact rules, documents and fees vary by bank and country, so confirm with your own bank.
What a letter of credit is
A letter of credit (L/C), also called a documentary credit, is a written undertaking by a bank to pay a named seller a stated amount, provided the seller presents documents that comply exactly with the terms set out in the credit. The key idea is that the bank deals in documents, not in goods. If the documents match, the bank pays; if they do not, it can refuse, even over a small discrepancy. That document-first principle is what gives the seller confidence and the buyer control.
The parties involved
| Party | Role |
|---|---|
| Applicant | The buyer, who asks their bank to open the credit |
| Beneficiary | The seller, who will be paid under the credit |
| Issuing bank | The buyer's bank, which issues the L/C and undertakes to pay |
| Advising bank | A bank in the seller's country that passes on the credit |
| Confirming bank | A bank that adds its own guarantee to the issuing bank's (optional) |
The step-by-step flow
- The buyer and seller agree to settle by letter of credit and write the terms into their contract.
- The buyer (applicant) asks the issuing bank to open an L/C in the seller's favour.
- The issuing bank sends the credit, usually through an advising bank near the seller.
- The seller checks that the terms are ones they can meet, then ships the goods.
- The seller presents the required documents — typically a commercial invoice, transport document and any certificates named in the credit.
- The banks examine the documents against the credit. If they comply, the issuing bank pays and collects from the buyer; the buyer receives the documents needed to claim the goods.
If the documents do not match the credit exactly, the bank may raise a discrepancy, and payment can be delayed or refused until it is resolved or the buyer agrees to accept it.
Pros, cons and costs
The main benefit is risk reduction: the seller is paid by a bank once compliant documents are presented, and the buyer knows payment is released only against proof of shipment. This makes L/Cs useful between new partners, for high-value orders, and across borders.
The trade-offs are cost and complexity. Banks charge fees — for issuing, advising, confirming, amending and examining documents — and the exact amounts and who pays them vary by bank and country. The process is also document-heavy and unforgiving: a typo or a missing signature can trigger a discrepancy. Both sides need to prepare documents carefully and watch the deadlines in the credit.
Because of that cost and effort, letters of credit tend to suit larger or riskier deals rather than small, routine orders, which often use simpler methods.
Where it fits in your process
An L/C is a settlement tool, not a substitute for choosing a sound partner. Verify the company first — browse verified suppliers on Digibition — agree your specifications and terms over direct messaging and calls, and only then settle on how payment will flow.
Key takeaways
- An L/C is a bank's promise to pay the seller against compliant documents, not against the goods themselves.
- It replaces company-to-company trust with bank-backed assurance, which suits new or cross-border partners.
- It is more expensive and document-heavy, so it fits larger or higher-risk deals.
- Rules, documents and fees vary by bank and country — confirm with your bank.
This is general guidance, not legal or financial advice; your bank and a qualified professional govern the specifics. Start with a partner you can trust — find a verified supplier.
Frequently asked questions
- Who pays the fees on a letter of credit?
- It is negotiable and set out in the contract. Commonly the buyer (applicant) pays the issuing bank’s charges and the seller pays charges in their own country, but confirming and other fees can be split differently. The exact split and amounts vary by bank and country.
- What is a discrepancy in a letter of credit?
- A discrepancy is any way the presented documents fail to match the exact terms of the credit — a wrong date, a missing document, an inconsistent description. Because banks deal in documents, even a small discrepancy can delay or block payment until it is resolved or the buyer waives it.
- What is the difference between a confirmed and an unconfirmed letter of credit?
- An unconfirmed L/C relies only on the issuing bank’s promise to pay. A confirmed L/C adds a second bank’s guarantee, usually one in the seller’s country, which gives the seller extra protection if the issuing bank or its country poses risk. Confirmation adds cost.
- Does a letter of credit guarantee the goods are good?
- No. A bank deals in documents, not goods, so it pays against compliant paperwork regardless of the actual quality of the shipment. Inspection, certificates and clear specifications in the contract are how you protect against quality problems.
- When is a letter of credit worth the cost?
- It is most often considered for larger, higher-risk or cross-border deals between partners who do not yet trust each other, where the protection outweighs the fees and paperwork. Small, routine or repeat orders frequently use simpler methods. Consult your bank.