The sales agreement is not part of a letter of credit. The buyer might not pay for several reasons (the buyer’s assets could be seized for some reason, the buyer might go bankrupt, and so on). For example, if the seller spends money to produce and ship goods, the seller wants to recoup those costs. Perhaps this buyer and seller have never worked together, or the order might be large enough to cause severe financial hardship if something goes wrong. Why does the seller demand a letter of credit? The seller wants more confidence that the buyer will pay. As part of the contract, we assume that the seller requires the buyer to use a letter of credit (LOC). They agree on a price, quantity, and other terms, and they specify how and when the goods will be shipped to the buyer. For now, the idea is just to get comfortable with the flow of documents and payments with LOCs.įirst, a buyer (importer) and seller (exporter) decide to do business together. This tutorial illustrates the basic concepts, but a real transaction is much more complicated than what you see here. The importer would be the contractor’s customer. The exporter could be a contractor that promises to complete a project by a specific date. The importer would be a customer that buys energy from the utility. The exporter could be an electric utility company that sells power.If you want to see how a LOC works for common domestic transactions, replace the terms “importer” and “exporter" with a customer or service provider in your industry. for a variety of services, including building projects, signing up for electrical service, and more. However, LOCs are useful in several types of transactions. Standby letters of credit, for example, can work within the U.S. You can also just read an overview if you prefer a text-only explanation without the visuals.įor this example, we assume that an importer is buying goods from an exporter. The easiest way to understand how LOCs work is to see an example, and this tutorial describes the process step-by-step. A letter of credit (LOC) is a promise from a bank to make a payment after verifying that somebody meets certain conditions.
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