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, a letter of credit and a line of credit, each has different structures and purposes.
Both are important to the function of businesses, and any small business owner should understand the difference between a letter of credit vs a line of credit.
What is a Letter of Credit?
Simply put, a letter of credit is to guarantee payment for a single transaction between two businesses.
A letter of credit is a document issued by the bank to the seller at the request of the buyer, and it guarantees that the buyer will make the payment on time to the seller within the terms outlined in the letter. If the buyer does not make the payment, the bank or financial institution that issued the letter will pay the seller. When issuing a letter of credit, a bank may take a percentage of the size of the letter of credit as a fee.
A letter of credit ensures the buyer or buyers will pay on time and in full. It is often used as a negotiation tool in business, as well as assurance. Without a letter of credit, there is a chance the seller may question the buyer’s ability to pay after shipping goods, while the buyer may worry about losing money if the seller never ships the goods. A letter of credit allows peace of mind when conducting transactions.
You will most often see letters of credit being used in international trade due to the differing laws and customs between countries to help facilitate business.
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:
Revolving Letter of Credit
A revolving letter of credit is a document that covers several transactions over a period of time. It’s often used for a regular shipment of the same goods between the buyer and seller. The letter is issued once for a certain period of time, or it can be issued for a certain number of transactions, which avoids having to get a new letter for every new transaction.
Commercial Letter of Credit
A commercial letter of credit allows a different bank than the one issuing the letter of credit to make a direct payment to the beneficiary.
Traveler’s Letter of Credit
As it says in the name, a traveler’s letter of credit is intended for those traveling, particularly in foreign countries. The letter guarantees that the issuing bank will honor drafts made at some foreign banks.
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.
What is a Line of Credit?
While a letter of credit is primarily between the buyer and seller, a line of credit exists between a bank or other financial institutions and the borrower or business. A line of credit is a flexible loan with a specific amount of money that the business can access as needed and pay back either over time or immediately.
Lines of credit are used to cover financial gaps or for projects with unpredictable costs and are helpful for those avoiding traditional small business loans that often have more restrictions on usage.
Businesses can use them for a variety of payments, such as for the purchases of new goods, marketing, or even paying electric bills, as long as it’s within a fixed amount. They are useful to small business owners who may need extra cash flow from time to time. Once the money in a line of credit is spent, interest begins to compound on it; it remains interest-free as long as it’s not being used.
Although they are helpful to small business owners, a line of credit can often be a type of unsecured line, which is not tied to any valuable property the borrower may own and can have higher interest rates. They are also typically not tax deductible.
Lines of credit are often compared to credit cards, as they limit how much money you can borrow, and you can use it towards anything you wish and charge interest when there is a balance.
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 international trade transactions that have inert risk involved. It guarantees that if payment does not come through or the goods are not delivered, the financial institution will pay the amount stated in the letter. A letter of credit can be used only once.
Line of Credit
A line of credit is used by businesses to help with cash flow. The bank will issue an amount of money that the business can use at any time for almost anything. Once the money is used, the borrower must pay it back either immediately or over time with interest. A borrower can use the line of credit multiple times, up to the limit issued.
Parties Involved
Letter of Credit
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
Only two parties are involved with lines of credit: the bank and the borrower. Only the approved borrower is allowed to use the money the financial institution has loaned.
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. After that, there are no other fees or interest.
Line of Credit
Borrowers are usually charged a fixed fee from the bank when receiving their line of credit, as well as interest on the borrowed amount that has been spent. Interest rates on lines of credit tend to be higher than traditional loans.
Which Is Right for Your Business – Letter of Credit vs Line of Credit?
While they both have credit in the name, letters of credit and lines of credit are related only in that they deal with credit.
A letter of credit is a document used for transactions between businesses, traditionally for international trade, that is issued and backed up by the bank to guarantee payment will be made.
Although a bank or other financial institution also issues a line of credit, it is between the bank and the borrower only and is used to help with cash flow. Lines of credit are good options for small business owners or start-ups that need extra money to help with projects that have no predictable costs or to help buy goods to sell until they can make a strong profit.
At SouthEast Bank, we will take the time to help you understand the difference between the two and work with you to find the right solution for your small business.
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Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An attorney or tax advisor should be consulted for advice on specific issues.
