What is a Usance Letter of Credit?
A usance letter of credit is a specific type of letter of credit that allows a predetermined credit period to the buyer, i.e., the importer. In common business usage, a usance letter of credit is also known as a deferred letter of credit.
Types of Usance Letter of Credit
Letters of credit are payment instruments used to facilitate international trade transactions. The primary purpose of a letter of credit is that it helps mitigate the risk associated with international trade for both the buyer and the seller. However, as with any payment instrument, letters of credit also have multiple secondary purposes. There are many types of letters of credit, each serving a different purpose for either the buyer, i.e., importer, or the seller, i.e., exporter, or both. One such type is the usance letter of credit.
A usance letter of credit provides a deferred payment option to the buyer. The tenor of payment is pre-decided by the buyer and the seller. The usance letter of credit can be classified into two based on their tenor. The usual tenors can be as follows:
Payment within 90 days after the bill of lading (B/L)
This means that after the B/L is issued, the buyer has a time of 90 days from the date of B/L to make the payment for the goods.
Payment within 30 days after sight
This means that on the date that the issuing bank receives the documents, from that date, the buyer has 30 days to make the payment for the goods.
Let’s understand the usance letter of credit with an example –
Example of Usance Letter of Credit
Example – Mr. James (importer/ buyer) residing in the USA decides to buy goods worth USD 50,000.00 from Mr. Ravi (exporter/ seller), who is based in India. Mr. Ravi wants to use a letter of credit for payment as he wants to mitigate risk. Mr. James insists on using a usance letter of credit for the transaction as he wants a credit period of 60 days to pay for the goods. Mr. Ravi agrees, so Mr. James applies for a usance letter of credit of USD 50,000.00 in the name of Mr. Ravi from Bank of America. Mr. Ravi nominates Axis Bank, India, as his advising bank.
Following is the sequence of the transaction –
- On February 1, 2018, based on the application of Mr. James, Bank of America issues a usance letter of credit of USD 50,000.00 in the name of Mr. Ravi and sent it to Axis Bank, India. The term of usance letter of credit is “payment of USD 50,000.00, 60 days from the date of Bill of Lading.”
- Axis Bank forwards the usance letter of credit to Mr. Ravi. He checks the terms and accepts them.
- On April 1, 2018, Mr. Ravi manufactures and ships the ordered goods (amounting to USD 50,000.00) to Mr. James. He receives a bill of lading dated April 2, 2018, from the shipping line.
- On April 10, 2018, Mr. Ravi submits the original shipping documents (invoice, packing list, bill of lading, etc.) along with an original letter of credit to Axis Bank, India.
- Axis Bank, India reviews the documents and forwards them to Bank of America.
- Then the Bank of America reviews the documents and passes them on to Mr. James, who accepts the documents on April 17, 2018.
- Now even though Mr. James has received the documents, he doesn’t need to pay immediately. He has 60 days from the date of the bill of lading to make the payment. This means he can make the payment any time before May 31, 2018 (i.e., 60 days from April 2, 2018 )
- James receives the goods on May 5, 2018. He opens and checks the goods and starts using them.
- James makes the payment of USD 50,000.00 on May 28, 2018, to Bank of America. Bank of America transfers the payment to Axis Bank, India. Axis Bank deducts its own advising charges and transfers the remaining payment to Mr. Ravi’s account.
So this is how Mr. James took advantage of the usance letter of credit and got a credit period of two months.
Usance Letter of Credit Vs. Sight Letter of Credit
Many people get confused between a usance letter of credit and a sight letter of credit, when in fact, they are exactly opposite to each other. While in the usance letter of credit, there is an option of deferred payment for the buyer, in the sight letter of credit, the buyer has to make the payment for the goods immediately after he receives the documents. In the above example, as it was a usance letter of credit, Mr. James could make the payment on May 28, 2018. While in a sight letter of credit, Mr. James would have to make the payment maximum by April 17, 2018.
Advantages and Disadvantages of Usance Letter of Credit
The major advantage of a usance letter of credit falls on the buyer, who gets a credit period to make a payment. The buyer doesn’t get a deferred payment option in any other type of letter of credit. This means interest-free working capital for the buyer. It also results in more efficient working capital management. Furthermore, an important aspect to consider is that when using a usance letter of credit, the buyer may receive the goods even before making the payment. That way, he gets to check the quality of goods before making the payment.
In contrast, the same set of advantages becomes a disadvantage for the seller. The seller has to manage stretched-out working capital as he gives a credit period to the buyer.
So the bottom line here is that a usance letter of credit is usually used when the buyer has the upper hand over the seller or if it is a buyer’s market. Due to this reason, the seller agrees to oblige to the lenient terms of a usance letter of credit.