Difference Between Letter of Credit and Buyers Credit

Introduction

The difference between the letter of credit and buyer's credit is a common confusion for many. Both are products offered by banks to facilitate international trade. Even though both facilitate international trade, they are completely different products. People often confuse the two terms because of the similarities between the two. There are significant differences between a letter of credit and a buyer's credit. Both work on different platforms. Yet they fulfil almost the same purpose. Both payment instruments are equally secure. However, buyers' credit is a little more expensive. The documents required for the approval of the two are completely different. The structure of both is altogether different and is very useful for business people. A letter of credit, also known as a credit letter, is a letter availed from a bank that guarantees that a buyer's payment to a seller will be received on time and for the correct amount. A buyer's credit is a short-term loan facility extended to an importer. It is extended by an overseas lender like a bank or a financial institution to finance the purchase of capital goods and services. This article attempts to explain the critical differences between the two concepts in a tabular form and in points. It also aims to demonstrate both the topics in detail for a clear understanding of both the terms.

Letter of Credit vs Buyers Credit

The critical difference between a letter of credit and a buyer’s credit is that a letter of credit is available to and may be used by any ordinary individual for one of the most significant business transactions, while buyers’ credit is mostly available only for high-end purchases, or a massive import/export deals involving large amounts of money. In a transaction involving a letter of credit, there are usually four parties involved – the buyer, the buyer's bank, the seller, and the seller's bank. On the other hand, in a buyer’s credit transaction, there are only three parties involved – the buyer, the buyer's bank (domestic), and the offshore bank that provides the credit facility. The main aim of a letter of credit is to become an intermediary or a payment instrument that can pay off any debt, whereas the main aim of a buyer's credit is to provide a loan or a credit facility that needs settling later with a higher rate of interest. The legal obligation falls on both the parties involved in the case of a letter of credit, while the legal obligation falls on the importers in the buyer’s credit. In a letter of credit, the purchase, as well as sale, takes place between the parties involved. Movement of the document and money also takes place. However, in the buyer's credit, only a transfer of funds is made between the parties. It is limited to funds only and does not involve movement of documents, and thus has a lesser scope compared to a letter of credit.

Difference Between Letter of Credit and Buyers Credit in Tabular Form

Parameters of Comparison	Letter of Credit	Buyers Credit
Definition	A letter of credit is defined as a piece of document that ensures the settlement of payment to the seller. It is issued on behalf of the buyer. It can only be issued by a commercial bank or a financial institution, and it specifies the date and time to repay the total amount to the seller.	A buyer's credit can be defined as a credit facility for those people who are related to the import and export business. The buyer receives credits from an offshore bank of the importing country to pay off the exporter. The buyer is legally obligated to pay that amount later with interest.
Cost	Banking institutions only charge a nominal amount as a fee for issuing a letter of credit since it does not include any fund borrowing. Therefore, no interest is charged on it.	Buyer's credit involves a large amount of fund borrowing. Thus, banks charge a high rate of interest and processing fees as well.
Parties involved	In a transaction involving a letter of credit, there are usually four parties involved– the buyer, the buyer's bank, the seller's bank, and the seller.	In a transaction involving a buyer's credit, there are three parties involved – the buyer, the buyer's bank (domestic), and the offshore bank that provides the credit facility.
Aim	The aim of a letter of credit is to become an intermediary or a payment instrument that can pay off any debt.	The aim of a buyer's credit is to provide a loan/credit facility that is settled later on at a high-interest rate.
Scope	In a transaction involving a letter of credit, the purchase and sale take place and also consists of the movement of documents and money	. In a transaction involving the buyer's credit, only the transfer of funds is made between the parties. It is limited to funds only and does not involve the movement of documents, and thus has a lesser scope when compared to a letter of credit.
Legal obligation	The legal obligation is imposed on both the parties involved in a transaction of a letter of credit.	The legal obligation is imposed on the importers in the buyer's credit.
Used by	A letter of credit is available to and may be used by any ordinary individual for one of the most significant business transactions.	Buyers' credit is primarily available only for high-end purchases or massive import/export deals costing millions of dollars.

What is a Letter of Credit?

A letter of credit that is also known as a credit letter, is a letter issued by a commercial bank that guarantees that a buyer's payment to a seller will be received on time and for the correct amount. If the buyer is incapable of repaying the loan amount due to any reason for the purchase, the bank is obligated to cover the whole/remaining amount of the purchase. It may be offered as a facility.

Types of Letters of credit

1. Commercial Letter of Credit-This is a direct payment method in which the issuing bank makes the payments to the beneficiary.
2. Standby Letter of Credit-This is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.
3. Revolving Letter of Credit-This kind of letter of credit allows a user to make any number of draws within a specific limit during a particular time period.
4. Traveller’s Letter of Credit-For those going abroad, this letter will guarantee that issuing banks will honour drafts made at certain foreign banks.
5. Confirmed Letter of Credit-A confirmed letter of credit involves another bank other than the issuing bank that guarantees the letter of credit. This additional bank is the confirming bank (typically the seller's bank). This confirming bank ensures payment under the letter of credit if the holder and the issuing bank default due to any reason. The issuing bank in international transactions generally requests this arrangement.

Working on a Letter of Credit

In international trade, the facility of a letter of credit is generally used to signify that full payment will be made to the seller at a particular time, as guaranteed by a commercial bank or a financial institution. After issuing a letter of credit, the commercial bank will charge a fee. This fee is generally a percentage of the letter of credit, in addition to requiring collateral security from the buyer of goods.

What is Buyers Credit?

A buyer's credit is a short-term loan facility that is extended to an importer by an overseas lender like a bank or a financial institution to finance the purchase of capital goods and services. The importer (the person to whom the loan is issued) is the buyer of goods, and the exporter is the seller of goods. Buyer's credit is a valuable financing method in international trade since it gives the importer access to cheaper funds when compared to local funds available.

Merits of Buyers’ Credit

1. It is a convenient as well as a continuous source of funds
2. It may be readily available in case the credit worthiness of the customers is known to the seller
3. If an organisation wants to increase its level of inventory to meet the expected rise in sales volume soon, it may use buyers' credit to finance the same.
4. It does not create a charge on the assets of the firm since there is no collateral while providing funds.

Limitations of Buyers' Credit

1. The availability of accessible and flexible buyers' credit facilities may induce a firm to indulge in overtrading, which may add to the risks to the firm
2. Only a limited amount of funds can be generated through buyers' credit
3. It is generally a more costly source of funds when compared to most other sources of raising money.

Steps involved in buyers' credit

1. The exporter enters into a commercial contract with an importer. Such a contract specifies the goods or services supplied and the prices and payment terms.
2. Then, the buyer obtains credit from a financial institution or a bank for the purchase. An export credit agency operating in the exporter's country provides a guarantee to the lending bank to cover the risk of default
3. . After the exporter ships the goods, the lending bank pays the exporter according to the terms specified in the contract. The buyer makes principal payments and interest payments to the lending bank according to the loan agreement until the loan amount is fully repaid.

Main Differences Between Letter of Credit and Buyers Credit In Points

1. A letter of credit is defined as a piece of document ensuring that the payment will be settled to the seller that is issued by a bank or a financial institution. A buyer's credit can be defined as a credit facility for those people who are related to the import and export business, where the buyer is legally bound to repay the credit on a specified date along with a predetermined interest rate.
2. Since a letter of credit is just a guarantee and does not involve borrowing of fund, banking institutions only charge a nominal amount for issuing it. No interest is charged for issuing a letter of credit while banks charge high rates of interest on buyers’ credit as they are issuing the funds to an induvial.
3. The four parties involved in a transaction of a letter of credit and buyers’ credit are – the buyer and his bank, and the seller and his bank. In a transaction involving buyers credit, there are only 3 parties involved – the buyer and his domestic bank and the offshore bank that provides the credit facility to the buyer.
4. The main aim of a letter of credit is to provide guarantee for repayment of funds to the seller and to become an intermediary that can pay off the debt. However, the aim of a buyer's credit is just to provide a loan/credit facility that will be repaid on a specific date at a predetermined interest rate.
5. In a transaction involving a letter of credit movement of documents and money is made. However, in the buyer's credit, only the transfer of funds is made between the parties, i.e.; it does not involve the movement of documents. This implies that buyers credit has lesser scope when compared to a letter of credit.
6. The legal obligation is imposed on both the buyer and the bank in a letter of credit, while the legal obligation falls on the buyer of goods in the buyer's credit.
7. Letter of credit is available to and can be used by any ordinary individual for transactions while buyers' credit is generally available only for purchases involving large amount of funds or a massive import/export deals involving large companies.

Conclusion

There are significant differences between a letter of credit and a buyer's credit. Both works on different platforms and yet fulfil almost the same purpose. Both payment instruments are equally secure and safe to use for any transaction. Buyers' credit is a little more expensive than a letter of credit. The documents required for the approval of both are completely different too. The structure necessary for both these credit facilities is also different and is very useful for business people. This article has attempted to explain the critical differences between a letter of credit and a buyer's credit. Further, it has described the concept of a letter of credit in detail, covering its working and types. It has also demonstrated the idea of buyers' credit and given a gist of the steps involved, its merits and limitations.