Money is the main medium of exchange for goods and services. It comes in two forms, coins, and banknotes. It is used to make payments for items purchased as well as settle debts and so on. The business world cannot function without the presence of money.
Line of credit and letters of credit play their major-specific roles among buyers, sellers, loan borrowers, and financial institutions or banks. While the Letter of Credit and Line of Credit seem to sound similar, they are of different meanings and hold different functions. As a business owner, it is important to understand the main differences between a line of credit and a letter of credit.
Letter of Credit Vs. Line of Credit
A letter of credit is a document that the bank issues to the seller once the buyer makes a request. A line of credit on the other hand is a financial instrument that aids a customer to borrow a specific maximum amount from the bank.
A letter of credit cannot be issued unless the buyer has requested the same. It helps to fix the maximum amount that the person can borrow from the bank at any time.
Comparison between Letter of Credit and Line of Credit
- A letter of credit is a document that ensures the buyer does prompt payment to the seller. A line of credit on the other hand is an instrument that offers support to a business or an individual, through financial loans.
- The letter of credit is a rigid document. It is only applicable once and ensures that the buyer has made payment to the seller. The line of Credit on the other hand offers flexibility, whereby a customer can borrow any time using the fixed amount.
- A letter of credit is not issued unless a fixed fee, which is payment for the letter, is made. There are no interests incurred. A line of credit also has a fixed fee but offers interest rates for the funds borrowed by the customer.
- There are only four entities involved in a credit letter. The buyer, the seller, and their two respective banks. The line of credit involves only two entities, which are the customer or borrower and the specific financial institution.
- Letters of credit are mainly used globally where the seller and the buyer are from different countries. A line of credit is only used locally and in the specific country of the customer.
What is a Letter of Credit?
A letter of credit is a financial document or instrument issued to the sellers upon the request of the buyer. These letters are mainly used for international trade where both the seller and the buyer reside in different countries.
Once the seller shows proof of shipping the goods and services, the letter of credit helps to ensure that the payments are made on time and without fail. The absence of a credit letter makes the seller think that the buyer is not ready to make payment for the shipping costs as well as for the goods and services. This absence puts the seller and the buyer in the thought of their losses.
A letter of credit is needed to ensure a smooth process as well as promote honesty and authenticity of the buying and selling process. Once the buyer opens the credit letter containing the seller’s name, payments should only be made using that name.
A financial institution collects the credit letter fee according to the size of the letter.
There are several credit letters available today, they include:
- A commercial letter of credit.
- A revolving letter of credit.
- Traveler’s letter of credit.
- Confirmed letter of credit.
A letter of credit is issued within two days.
What is a Line of Credit?
This is a financial instrument between a customer or borrower and the financial institution. A customer can borrow a maximum amount using the line of credit up to the fixed amount at any given time.
The line of credit is used for different purposes including; purchasing, investing in the business, day-to-day activities, or just spending without paying the immediate amount. There is a fixed amount for the line of credit letter and interest incurred for the amounts borrowed.
Unlike the letter of credit, a line of credit is flexible and the customer or borrower can use it whenever they want. The borrower can use this line of credit for utility bill payments, credits, and purchase of material, goods, and investing in the business.
There are only two parties involved in the line of credit. That is the customer or borrower and the financial institution.
Most lines of credit are unsecured and therefore have a higher interest rate. A credit card is an example of a line of credit.
Individuals are more attracted to a secured line of credit as it provides maximum credit and lowers interest rates.
There are different forms of the line of credit and they include:
- A personal line of credit
- Home equity line of credit
- Demand line of credit
- Securities- a backed line of credit
- A business line of credit.
The advantage of the line of credit is that you only borrow the funds you need and this protects you from paying unnecessary high interests.
Difference between Letter of Credit and Line of Credit
- A letter of credit is issued by the bank to the seller upon request of the buyer while a line of credit is an instrument used by the customer or borrower to request funds from the financial institution.
- Letters of credit are used to make payments to the seller during international transactions while the customer to borrow loans uses the line of credit.
- A letter of credit is rigid and is only used once while the line of credit is a flexible instrument.
- A letter of credit is only issued upon payment of the fixed fee while the line of credit has a fixed fee and an interest incurred on amounts borrowed.
In conclusion, both the letter and line of credit documents may sound similar but they are completely different documents with completely different functions.