Letter of Credit is a kind of document that provides guarantee to a lender that the borrower would pay back the borrowed amount and if the borrower fails to do so, the guarantor will pay that. This is becoming an important mode of transaction for a number of sectors.
A letter of credit can be termed as a specific document that is issued in certain situations by banks or other lending institutions. The nature of this letter can be termed as a request letter. This letter is provided by the financial institutions to the potential borrowers. Through this letter, the borrower gets the chance to draw an exchange bill that is definitely accepted.
Role of the financial Institution in offering Letter of Credit
The letter of credit that is issued by the financial institutions is a special type of document where the lending institution plays the role of a guarantor for some other person.
According to this letter of credit, a financial institution requests a person to provide a definite amount to a particular person. This amount is treated as a debt. So, the role of the bank or the financial organization here is similar to a guarantor. There are certain individuals who also offer this type of letters but basically it is related to the banks. Whenever any individual issues letter of credit, it becomes essential for the involved parties to handle the risk factors properly.
The letter of credit is also important because through this letter, the bank or the financial institution that issues the letter comes under certain obligation. Because of this letter, instead of the borrower, the letter issuing body comes under the obligation of making the payment if the borrower defaults for any reason.
Uses of Letter of Credit
There are a number of uses of a letter of credit. These can be used as a mode of payment in the transactions. There are a number of exporters who receive payment through these modes. The letter of credit is becoming a crucial part of the land development processes where it ensures growth of the public facilities. On the other hand, the letter of credit is becoming very important for the international trade and commerce. It provides an easy transaction system for the businesses where customer and the supplier belong to different nations.
Charges for Providing Letter of Credit
The bank or the financial institution that provides the letter of credit is always exposed to a huge amount of financial risk. Because of this, a certain amount is charged by the letter of credit providers. The applicant is bound to pay this amount to the issuer of this letter. At the same time, the applicant has the right to ask for the same amount from the beneficiary.