If you’re a business looking for financial backing, you may have heard the terms letter or credit and line of credit and wondered what the difference is between them. Although they have similar names, they do have unique purposes and structures respectively.
Both can be important tools that can help finance your business, and understanding the difference can help small business owners determine which one best supports their financial needs.
What Is a Letter of Credit?
Simply put, a letter of credit is a guarantee of payment for a transaction between two businesses. It is a document issued by a financial institution on behalf of the buyer, assuring the seller that they will receive payment under the agreed-upon terms. If the buyer fails to pay, the issuing bank covers the cost subject to the terms of the letter of credit.
Letters of credit are often used as negotiation tools in business transactions, providing assurance to both the buyer and the seller. For example, a seller might hesitate to ship goods without knowing they will get paid, and a buyer might worry about paying for something they haven’t received. A letter of credit provides peace of mind to both parties.
This tool can be helpful in international transactions, where differing laws, currencies, and business practices can make them more complex.
Types of Letters of Credit
There is more than one type of letter of credit available to businesses. Each one has a specific use, depending on the needs of the buyers and sellers. The types of letters of credit that are available are:
Standby Letter of Credit – The standby letter of credit provides for payment on behalf of the seller if the buyer defaults on the agreement.
Revolving Letter of Credit – A revolving letter of credit covers multiple transactions over a set time period, ideal for regular shipments between the same buyer and seller.
Confirmed Letter of Credit – Confirmed letters of credit involve two banks: the one issuing the letter and another, typically the seller’s bank, which is the confirming bank. The confirming bank is the one that ensures the payment on the letter of credit if the holder and the issuing bank default.
Commercial Letter of Credit – A commercial letter of credit provides the bank to make a direct payment to the beneficiary on behalf of the borrower.
What Is a Line of Credit?
A line of credit (LOC) works differently from a letter of credit. A LOC is a flexible loan agreement between a borrower and a financial institution in which the borrower is approved for a set amount of money they can draw from as needed. Interest accrues on funds that have been drawn and not yet repaid.
LOCs are often used to cover financial gaps, fund ongoing projects, or manage fluctuating expenses. They are especially helpful for small business owners looking for short-term financial support without the rigid terms of a traditional loan.
These accounts function similarly to credit cards: you can borrow up to your limit, repay the amount, and borrow again. However, unsecured lines of credit may carry higher interest rates.
The Differences Between a Letter of Credit vs Line of Credit
Letters of credit and lines of credit are two very different financial terms, each with different purposes and parties involved.
Purpose and Usage
- Letter of Credit – Letters of credit are used for domestic and international trade transactions that may have higher risks. They generally establish prompt and accurate payment to the seller subject to the terms of agreement, which may include multiple transactions over a limited period of time.
- Line of Credit – Businesses may use lines of credit to manage cash flow by leveraging its revolving feature. A borrower can draw from the line of credit multiple times, up to the credit limit. When the principal is paid back, funds become available for use again. A line of credit may also be used for domestic or international transactions.
Parties Involved
- Letter of Credit – At least three parties are involved in a letter of credit: the buyer, the seller, and the financial institution, such as a bank. Letters of credit can be transferred, but it must be documented in the letter and approved by the bank.
- Line of Credit – Generally, there are two primary parties involved with a line of credit: the financial institution and the borrower. The borrower and authorized signers are allowed to draw funds from the line of credit.
Fees and Rates
- Letter of Credit – Banks typically charge either a set fee or a percentage of what the letter of credit is when issuing the letter. There may be additional fees, depending on the type of letter of credit and other factors.
- Line of Credit – Borrowers are usually charged an origination fee from the bank when receiving their line of credit, as well as interest on drawn, unpaid funds. Interest rates and other fees may depend on a variety of factors.
Final Considerations
While both letters of credit and lines of credit involve financial institutions and credit terms, their use cases differ significantly.
A letter of credit is best suited for businesses engaging in large or international transactions where trust and security are essential. On the other hand, a line of credit can help manage day-to-day operations, provide working capital, or offer backup funding for seasonal fluctuations.
At SouthEast Bank, we understand the needs of growing businesses. Whether you need one-time transactional security or ongoing financial flexibility, our team is here to help you choose the right financial solution. Explore business banking products and services and schedule an appointment to take the next step for your business.
Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as financial, legal or tax advice. An attorney, financial advisor, and/or tax advisor should be consulted for advice based on your circumstances.
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