A deferred payment letter of credit comes with a payment clause at a certain date as agreed by two parties in a trade deal. The documentary credit works as a financial guarantee for the seller and mode of payment. For new trade deals and uncertain economic conditions, the buyer can request the issuing bank to release the payment at a certain date.
The deferred payment clause is added to ensure the timely delivery of goods to the buyer. Usually, the buyer would set the date by estimating the production, packaging, and shipping time. However, the arrangement delays the payment for the seller.
What is a Deferred Payment Letter of Credit?
Deferred payment Letter of credit or simply deferred payment LC is a type of letter of credit in which the bank releases the credit payment after a certain date. The payment date is set by the buyer and is usually the maturity date of the trade deal. The seller may negotiate the deferred payment date with the buyer. However, the seller cannot set the deferred payment with the issuing bank.
The sole purpose of deferred LC is to ensure the timely delivery of the goods. However, as it works usually on an estimated timeframe, it cannot guarantee the payment is made after receiving the shipment.
How Does Deferred Payment Letter of Credit Work?
The letter of credit must exclusively state the terms of deferred payment. It must include the payment date explicitly and inform the concerned parties in the trade deal. The buyer can request the issuing bank to issue a deferred payment credit in favor of the beneficiary.
The approved credit remains with issuing bank unless there is a confirming bank involved. The issuing bank may also transfer the credit to a nominated bank (advising bank or the seller) too.
Once the seller receives confirmation of documentary credit, it can proceed with the production of goods. The seller can ship the goods and present the necessary documentation to the advising or nominated bank. The nominated bank will release the credit payment on the mentioned date in the letter of credit.
As a common practice, the buyer requests the issuing bank to set the maturity date after the production of goods commences. The buyer can estimate the production time, shipping, and delivery time to set the maturity date of the LC. Usually, the buyer adds a few calendar days from 30 to 180 days after the production starts.
The sole purpose of the deferred payment LC is to ensure the timely delivery of the goods. It is used to reduce the friction between two new trade partners in international trade. The buyer can ensure the goods delivery while the seller can secure the payment through financial security. It works similarly to a sight LC with an additional clause of the maturity date of the documentary credit.
Key Points to Note with the Deferred Payment Letter of Credit
A deferred payment letter of credit works similarly to a sight letter of credit. The difference being the maturity date of the deferred payment LC. The nominated bank received the presentation papers from the seller but clears the payment upon the maturity in a deferred payment LC.
Some key points to note with a deferred payment LC are:
- The buyer can set a Calendar date by estimating the goods delivery time.
- The buyer can set the maturity date after a certain event such as the production of goods completion, warehousing, or shipping event.
- The buyer can simply add a few days after the sight letter of credit clearance.
- The seller can negotiate the maturity date with the buyer, but cannot set the date with the issuing bank.
- The nominated bank can release the funds only after the presentation of necessary documentation from the seller and at the maturity date only.
Suppose a buyer Green Star in the US orders electrical components from Blue tech in Germany. Green star can negotiate the trade terms and deferred payment clauses with Blue tech. It can then approach bank A in the US to issue a deferred payment letter of credit.
Suppose Green Star agrees to add 30 days after the production of the goods is completed. Once the seller i.e., Blue Tech completes the production it can present the documentation to the advising bank. After verification of the documents, the issuing bank will hold the payment for 30 Calendar days. Blue tech as a seller will have to comply with other terms as usual such as providing the bill of lading and invoices etc. to the buyer.
Advantages of a Deferred Payment Letter of Credit
The documentary credit provides financial security to the beneficiary. It can embed different clauses and take different forms to offer multi-faceted benefits to all parties. A deferred payment LC also provides several advantages to both parties:
- It offers financial security of confirmed payment to the seller.
- It eliminates the trust deficit in large trade deals between the new trade partners.
- The buyer can keep control by setting up the maturity date.
- The buyer has the choice of setting the maturity date by adding Calendar days or by an event such as after the presentation of the bill of lading.
- The seller can offer competitive prices as it receives delayed payments.
- The buyer can ensure other trade terms are met along with the deferred payment clause.
Disadvantages of Deferred Payment Letter of Credit
As with any documentary credit type, a deferred payment LC also comes with some limitations.
- The buyer may be at a disadvantage of higher prices as the seller may charge for compensation against delayed payments.
- The buyer may still face delays in goods shipment due to uncontrollable factors such as geographical or political problems. By the time, the deferred payment credit can be released by the bank.
- As with other forms of documentary credit, it cannot eliminate the risk of default for the seller.
A deferred payment letter of credit comes with a maturity date for the payment. It creates a cushion of extra time for the buyer to receive the goods on time. The seller can also ensure financial security with a documentary credit. However, the buyer keeps the control by negotiating the maturity date and issuing the deferred payment letter of credit.