Borrowers can use several types of loans and facilities offered by banks. Letter of Credit and Line of Credit are also two important types of loan facilities for the borrowers. Unlike a common notion, both offer contrasting features and utilization for the borrowers.
Let us discuss some key features and similarities between the two types of bank facilities.
A Letter of Credit is a formal arrangement between the issuing bank and the applicant (buyer) that works a financial guarantee. The bank assures the seller of the payment in case the buyer fails to pay. The bank acts as the financial security facilitator between a buyer and a seller, usually in international trade agreements.
A Line of Credit is an approved amount of loan for the borrower that can be used several times up to the arranged period. It offers great flexibility to the borrower as it can be reused by repaying the withdrawn amount.
Types – Letter of Credit and Line of Credit
A letter of credit can embed several features and types depending on the arrangement between the buyer and seller.
Some common types of Letter of Credit include:
- Irrevocable and Revocable Letters of credit
- Confirmed and unconfirmed Letters of credit
- Standby Letter of credit
- Silent Confirmation letter of credit
- Revolving Letter of Credit
- Back-to-back letter of credit
- Transferrable Letter of credit
- Red Clause Letter of Credit and Green Clause Letters of Credit
A Line of Credit is often a form of revolving or an open-end line of credit. However, it can embed different features and utilization that makes for the different types of Lines of Credit Loans.
- Revolving and Non-Revolving Line of Credit
- Personal Line of Credit; commonly known as Home Equity Loans
- Home Equity Line of Credit
- Demand Line of Credit
- Securities-backed line of credit
- A Business line of credit
- Line of Credit products – Credit cards
How it Works – Letter of Credit and Line of Credit
Both types of facilities are offered by the banks after appraising the creditworthiness of the applicant. However, the practical usage and procedure for both types of facilities differ significantly.
Letter of Credit
Buyers and sellers in an international trade agreement choose the letter of credit as a mode of payment and financial guarantee. The bank acts as a financial security provider for both parties. Once a trade deal is finalized, the buyer approaches the bank to issue a letter of credit. The bank approves the application after assessing the credit profile and issues the LC in favor of the seller. Upon trade terms completion, the seller receives the payment through the bank in the form of a Letter of Credit clearance.
Line of Credit
A borrower approaches the bank for a short-term financing facility. It can be a revolving or non-revolving credit facility. The bank assesses the creditworthiness of the applicant. Once approved, the borrower can utilize the funds as a line of credit. Unlike term loans, the borrowers incur interest charges only on the withdrawn funds. Borrowers can reuse the facility by partial or full repayment as many times as possible.
Both types of facilities work differently and offer contrastingly different features as well. It means the usage for both would also be different.
Let us see when and where should both facilities be used.
When to Use the Letter of Credit
Letter of credit is best suited for international traders. LC offers a form of financial security to both parties in international trade. It also works as a mode of payment. It serves several benefits to both parties in the trade deal.
Much like a loan facility, the bank will require an asset or cash as collateral that the borrower must pledge. The bank will also appraise the applicant’s credit profile. As letters of credit are risky credit facilities and involve cross-border parties, banks do not approve the facility easily. It is an expensive and complex credit facility that is normally used by large businesses involved in international trade.
When to Use the Line of Credit
A line of credit works best for short-term financing needs. Businesses can use it for supporting the fluctuating short-term cash requirements. The most common uses of a line of credit are working capital needs such as accounts payables, payroll, utilities, and overhead expenses.
Businesses with seasonal revenue can utilize the line of credit facility. Also, borrowers looking for quick liquidity solutions with cash shortages can consider the facility. It offers a flexible credit option as the borrower can use it multiple times with one approval and with interest on the withdrawn amount only.
Key Features – Letter of Credit and Line of Credit
Let us take a glance at some key features on offer with both types of credit facilities.
Letter of Credit
- It works as a form of financial guarantee for the beneficiary i.e., the seller.
- It secures the financial interests of both parties in a trade deal.
- The bank acts as the facilitator between the two parties.
- Banks usually charge a one-time fixed fee for issuing the letter of credit.
- The buyer can secure the interests by adding special features in a letter of credit such as a red or green clause.
- The applicant requires significant creditworthiness to get approvals from the issuing banks.
- In some forms of LCs, a secondary bank may be required as confirming bank.
- It can be a costly facility for small and medium-sized businesses.
Line of Credit
- Borrowers can get approval for a large credit facility once with no interest costs until they withdraw funds.
- It comes with flexibility as an embedded feature for the borrower as they can reuse it several times.
- It helps businesses fulfill their cash needs for short-term needs such as working capital.
- The interest is charged only on withdrawn amounts but banks charge high variable interest rates.
- The banks can impose further covenants to restrict cash usage by the borrower.
- Banks can revoke the facility under special economic circumstances or if the borrower’s credit score declines.
Summary – Similarities and Differences
Let us summarize the key similarities and differences in a letter of credit and line of credit.
|Feature||Letter of Credit||Line of Credit|
|Usage||International payments Financial Security Payment to sellers||Short-term financing Payment to sellers|
|Interest and Fees||High Fixed Fees||Fixed fee + Interest Costs Variable or Fixed Interest rates|
|Parties involved||Buyer, seller, and the bank(s)||Borrower and lender|
|Types||Several types on offer||Several features|
|Misc.||Payment instruments with strict requirements||Flexible, short-term financing solution|
|One-time approval and usage||One-time approval with multiple usage options|
|Banks require strict lending conditions, collateral, and credit score||Banks require collateral and credit score|