Due to the uncanny similarity in their names – many people get confused between a letter of credit and line of credit. However, the similarities don’t just end with the names. We must understand that both products are similar in some way so it can get confusing.
In this article, we try to point out the characteristics that differentiate the two products from one another.
Following are the main differences between the two products –
A letter of credit and a line of credit are very different instruments. A letter of credit is a financial document that a bank or financial institution issues on request of the buyer to the seller. In a transaction, the letter of credit guarantees that the buyer will make payment to the seller on time and at predetermined terms. In this, the bank says “if the buyer fails to pay, we (the bank) will pay”
Different from a letter of credit, a line of credit is an arrangement between a bank/ financial institution and its customer i.e. the borrower. The line of credit is the maximum amount of loan that the customer can borrow from the bank.
A letter of credit is used for a very specific purpose. It is a payment instrument for international trade transactions where the buyer and the seller are in different countries and there is an inherent credit risk involved in the transaction.
On the other hand, a line of credit is used when the borrower requires money to conduct day to day business. These are pre-approved funds which the borrower can use in the time of cash crunch or for expansion needs.
A letter of credit comes in many types, each type comes with the clauses that differentiate it from others. Some of the popular types include –
- A commercial letter of credit,
- A standby letter of credit,
- Confirmed (and unconfirmed) letter of credit,
- Revocable (and irrevocable) letter of credit,
- Back to back letter of credit,
- Red clause letter of credit,
- Revolving letter of credit, and many more.
Types of the line of credit include –
- Personal lines of credit,
- Home equity lines of credit (HELOC),
- Demand lines of credit,
- Securities-backed lines of credit,
- Business lines of credit, etc.
Fees and Rates
Banks charge a fixed fee for the letter of credit, but no interest is charged on a letter of credit. However, banks charge a fixed fee to set up the line of credit plus interest on the borrowed amount. For example, if a borrower has a line of credit of USD 10,000 but he borrows only USD 6,000 in a given year, then the interest will be charged only on USD 6,000.
Difference in Features
A letter of credit is rigid. Its purpose and the method of use is fixed and no changes can be made to these factors. In other words, the letter of credit can only be used as an instrument to aid payment between buyer and seller. If the buyer has opened a letter of credit and wants to make payment to a seller other than the one mentioned in the letter of credit, he cannot do it. The terms of the letter of credit don’t allow such flexibility.
Opposite is the line of credit, which provides much flexibility. The borrower can use funds up to a fixed amount for whichever purpose he likes. He can use it to pay creditors, buy raw materials, pay for utility or even buy machinery if he has the required limit.
In a letter of credit usually, four parties are involved in the process – the buyer, buyer’s bank, seller and seller’s bank.
In a line of credit, there are only two parties involved – the issuing bank and the borrower (or customer)
Geographically a letter of credit is a global financial instrument. The parties involved in the process can be located in different parts of the world. A buyer residing in the USA can issue a letter of credit in the name of his seller residing in China.
Conversely, the scope of the line of credit is comparatively local. The borrower applies and borrows from the line of credit from his banker, who is usually located in his own country. Though the borrower can use the line of credit to make payment internationally as well.
Number of Usages
Another very important feature that differentiates a letter of credit from a line of credit is the number of times each can be used. In almost all the letters of credit, the instrument can be used only once, for one transaction, unless stated otherwise in the terms. On the contrary, in a line of credit, the borrower can withdraw from the facility as many times as needed. For example, if a line of credit is set up for one year, then in that one year the borrower can withdraw funds five, twenty, fifty times, up to the prescribed limit.
With so many differences, why do people get confused? It’s because of the similarities between them. This would be a good place to point out the similarities of a letter of credit and a line of credit –
Similarities between Letter of Credit & Line of Credit
- Both letter of credit and line of credit is a form of credit extension from the bank. However, it is important to note that the line of credit has a very wide scope – to clarify a letter of credit can be a part of the line of credit.
- Both these instruments can be used as a method of payment to the seller. Also, the buyer can present both the instruments as a guarantee of payment to the seller.12