Letter of Credit

A letter of credit is a document from a regulated financial institution (a credit union or bank) that guarantees payment. There are several types of letters of credit. Letters of credit are often used when buying and selling; if a buyer fails to pay a seller, the institution that issued the letter of credit will pay the seller (assuming all requirements are met).

Similar to escrow services - the issuing institution acts as a "disinterested" third party (they don't take anybody's side), and they release funds only after certain conditions are met. Letters of credit are common in international trade, but they are also used in domestic transactions (such as construction projects).

Key points:

  • A letter of credit provides protection for sellers (or buyers)
  • Letters of credit are issed by financial institutions when a business
    • applies for one
    • and has the assets or credit to get approved
  • Letters of credit are complicated, it’s easy to make an expensive mistake when using one

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