Difference Between Letter of Credit and Line of Credit

Edited by Diffzy | Updated on: April 30, 2023

       

Difference Between Letter of Credit and Line of Credit

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Introduction

Money is a form of exchange for everything there is, such as property, clothes, food, land, utensils, materials, and so on. The such exchange was started earlier in the 1300s, even before grains and seeds were traded in exchange for shelter and many other things.

But the era of exchanging grains and seeds is far gone, and now even the era of exchanging hard cash will be far gone with the digital advancement in the world. Almost 83% of the transactions done today are online, and no hard cash is used. The government is trying to maintain more and more transparency between each transaction, which also makes it easier to track money for the economy.

The topics we are likely to discuss are similar to such transactions. Due to the vast development in each sector of the economy, there are a variety of options and many more subsets within each sector. Here is the subset of credit, i.e., letter of credit and line of credit. Both provide an extension of credit given by the bank. But that is the only thing common to both subjects; the functions and purposes of both topics are enumerated below.

Letter of Credit Vs. Line of Credit

The letter of credit and line of credit have different structures and purposes. A line of credit offers a customer the ability to withdraw the maximum limit payment from the bank for ongoing projects and business expansion, while a letter of credit is used for making transactions between two businesses with confirmations and acknowledgement of complete documents from buyers and sellers.

The letter of credit emerged in the 1700s and later started flourishing in international trade, and slowly the concept of a letter of credit was also established in Europe in the 1800s. However, the name and functionality were different, and the offers were limited due to the non-uniformity of national laws. The financial means of exchange were also less. In the year 1933, the international rules came into action, and the letter of credit came into full functionality. The International Chambers of Commerce (ICC) and the Uniform Customs and Practice for Documentary Credits (UCP) offered a better framework for banks to use LOCs for worldwide transactions. The first version of UCP, known as UCP 82, is now updated to UCP 600, which was amended in 2007.

The line of credit was started pretty much around the same time and spread all over the world with deliberate speed. The line of credit initially had the function of withdrawing money and paying the interest on the fees as per the contract decided during the period. Later on, the purpose of the line of credit increased, such as for personal and business use. For personal use, the credit was taken to consolidate high-interest debt, emergency funding, college tuition fees, home renovations, and so on. For business use, the credits are used for providing liquidity in the short term, for business expansion, for paying bills, and for purchasing materials.

Although both the letter of credit and line of credit have two things in common, they are both forms of credit extension from the bank, and this instrument can be used as a method of payment to the seller or buyer. But apart from that, the line of credit and letter of credit have very diverse functionality and are accommodating to many of their customers. Both the letter of credit and line of credit provide a variety of options for different sectors and different uses by the consumer. In the below paragraphs, we will learn the difference between a letter of credit and a line of credit. And any uncertainty about selecting the best option for your needs will vanish. 

Difference Between Letter of Credit and Line of Credit in Tabular form

Parameters Letter of Credit Line of Credit
Meaning A letter of credit is a financial document issued by a bank to the seller at the request of the buyer. The line of credit offers the customer the opportunity to borrow the maximum amount of money from the bank. 
Usage The LC is a type of payment used in global trade. The transaction between two businesses whose owners have never met. The LOC is used when one needs money for emergency funding, whether it be for business or personal use.
Scope The letter of credit isn't generally available for every individual, and this might differ from financial institution to institution. A line of credit is typically available to all individuals; however, after some use, the credit score determines how long a line of credit is beneficial.
Flexibility The letter of credit is stringent because its sole purpose is to transfer from buyer to seller in international trade. The line of credit is more flexible and reliable since the borrowed money from the bank can be used for personal or even business purposes.
Fees & Rates A bank or financial institution charges fees for letters of credit based on the offers and services they provide. There is no interest charged. The fees for the line of credit are fixed, and the interest rate is also applied. The interest rate is applied only to money that has been borrowed.
Parties Involved The letter of credit involves four parties: the buyer, the buyer's bank, the seller, and the seller's bank, for acknowledging all the documents for confirmation before payment. In the line of credit, only two parties are involved: the issuing bank and the borrower (customer).
Geography   The letter of credit is a global transaction instrument since the other party can be located anywhere in the world. Comparatively, the line of credit is pretty much used for local purposes.
Types
  • A commercial letter of credit
  • A standby letter of credit
  • Revocable & irrevocable letter of credit
  • Red Clause letter of credit 
  • Back-to-back letters of credit and many more.
  • A personal line of credit
  • Home equity lines of credit
  • Demand line of credits
  • Securities-backed line of credit
  • Business lines of credit and so on.

What is a Letter of Credit? 

The letter of credit (LC) is the chain of LCs and bills confirming the deal made between buyer and seller. Once the contract is concluded, the buyer's bank then supplies an LC to the seller. The seller then delivers the same LC to the carrier in exchange for goods and a bill of lading. Furthermore, the seller consigns the bill of lading to the seller's bank, and the same is again sent back to the buyer's bank and buyer for confirmation. Finally, the buyer's bank and buyer, after acknowledging the bill of lading, hand it over to the carrier as a green flag for exporting the goods.

The Letter of Credit (LC), also known as a "Letter of Undertaking" (Lou) or "Banker Commercial Credit," is a payment mechanism used for international trading for providing a guarantee from a creditworthy bank to an exporter of goods. These are only used for international financing when the dependability of the contract parties cannot be easily determined. Hence, two banks are involved, who would have an underwriter if the other party performed any malicious act such as not paying enough money, not having proper documents set for performing the contract, having invalid papers, and so on.

The LC makes it easy for both buyers and sellers to make international trade, even if they don't know each other. Since the bank is involved, the legal obligations of payment between the two parties have been discharged because instead of the buyer directly paying the seller, the buyer's bank deals with the payment after acknowledging the complete set of documents handed over by the seller. After the presentation of documents, the goods will be under the control of the issuing bank, which also provides them with any kind of protection and security required. And payment for all the requirements will be paid by the buyer to his bank.

In any event of non-payment by the buyer for the purchase, the seller can demand payment from the bank. The bank takes action based on the terms and regulations of the contract, and if it complies with the letter of undertaking, then the demand of the seller is honoured. The regulating bodies for such LCs and Lous are the International Chambers of Commerce, also known as Uniform Customs and Practices for Documentary Credits. In any of the aforementioned cases, some banks require collateral from the buyer, and a letter of credit is issued for which a fee based on a percentage of the LC balance is charged. 

What is a Line of Credit?

The line of credit (LOC) is the extended credit facility provided by banks and financial institutions to the government, business, or private individual customers, which allows the customer to draw the facility they need with funding. The line of credit can be of various types, such as demand loan, special purpose loan, term loan, discounting, overdraft limit, export packing credit, and so on.

Interest is applied to the amount of the credited line of credit in the same way that it is applied to loans, and lines of credit can also be secured by collateral or unsecured. Such lines of credit are only extended by banks, financial institutions, and other licenced lenders to creditworthy customers. Creditworthiness is determined by the cash flow, repayment history of the customer, credit score, current position in the market of the customer, their business, or firm, and many other factors.

The line of credit requires a fee for setting up, and the fee is paid to banks or financial institutions. The fees are required for registration, legal fees, arranging collateral if needed, performing some security checks, application fees, and so on. The fee may also be required to keep the credit facility open, which may be on a monthly, quarterly, or annual basis. Even when the money is not withdrawn, the annual fees have to be paid to keep the credit facility open, and such fees are called "unused line fees."

As previously stated, a line of credit can be secured or unsecured; the secured line of credit has lower interest rates and is less risky because collateral, such as an asset or a piece of property, is involved. An unsecured line of credit, on the other hand, carries a higher risk and interest rate because there is no collateral involved. But in some cases, when the lender couldn't borrow his losses from unsecured credit, the lender minimises the risk, charges a higher interest rate, and restricts the credit line limit.

A line of credit provides far more options than personal loans and is also more flexible, such that the borrowed amount can vary, the interest is paid on only the borrowed amount, and the amount can be disbursed as required by the individual. The only disadvantage of LOCs is that the fees for applying for and maintaining them are higher. Furthermore, proper use of a LOC can improve respective credit scores, resulting in advantageous offers and discounts on a variety of purchases. 

Main Difference between Letter of Credit and Line of Credit in Points

  • The key difference is functionality: a letter of credit is used for international financial trade, and one can buy and sell a piece of business or goods without having any connection with other parties. The line of credit is the credit given to the customer to borrow the maximum amount of money from the bank.
  • A letter of credit is used for international trade and deals. the trade between two businesses where the owners have not even met each other. The line of credit has many purposes since it can be used for personal and business purposes.
  • As aforementioned, the letter of credit is used for international trading and deals, which makes sure that the letter of credit can be used for global trading and deals. In the case of a line of credit, it is pretty much local; it might be based on region, state, or country.
  • The parties involved in the letter of credit are more than those involved in the line of credit. The parties involved in the letter of credit are the buyer, the buyer's bank, the seller, and the seller's bank. The whole chain of command is followed by the parties involved, and after the acknowledgement of every document by every party, the deal is finalised and moved forward. The parties involved in the line of credit are the issuing bank and the borrower; the only transaction happens when the borrower withdraws the money from the bank for personal or business use.
  • The fees for the letter of credit are the fixed rate given by the bank and are discussed beforehand with the customer. But the interest rate is not charged on the letter of credit. On the contrary, the line of credit has an interest rate charged upon the money that is being borrowed, and the fees are applied based on terms that might be monthly, quarterly, or annually.
  • The letter of credit is rigid in nature, as you can see from the fact that the only transaction that takes place is between the buyer's bank and the seller's bank, and the payment is made for the goods. In the case of a line of credit, the money can be borrowed for any maximum amount and used in an unlimited number of transactions.
  • A letter of credit is not generally available to everyone; only a promising entrepreneur, business owner, or well-established firm can benefit from one. The line of credit is available to every individual, but how long it will stay with the customer will depend on the usage of the line of credit and credit score.
  • There are many subsets of the letter of credit and line of credit that provide various applications based on the name of the scheme. The letter of credit has commercial letter credit, standby letter of credit, revocable and irrevocable letters of credit, and many more. Similarly, the line of credit has personal lines of credit, home equity lines of credit, and many more.

Conclusion

Due to the uncanny similarities in the names, many people get confused with both terms. As a customer, it is our right to be fully informed of the functions, rules and regulations, and limitations of the scheme provided by the banks and financial institutions.

Both schemes provide secured and unsecured alternatives, have fixed-rate fees, and also have many further subsets for different purposes. Unlike popular belief, both provide distinct features and applications for borrowers.

References

  • Letter of credit - Wikipedia
  • Line of credit - Wikipedia
  • Letter of Credit vs. Line of Credit | Sapling
  • Letter of Credit Vs Line of Credit - Accounting Hub (accountinghub-online.com)
  • Line of Credit vs. Letter of Credit: What’s the Difference? - SuperMoney

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"Difference Between Letter of Credit and Line of Credit." Diffzy.com, 2024. Thu. 29 Feb. 2024. <https://www.diffzy.com/article/difference-between-letter-of-credit-and-line-1133>.



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