Definition and Example of Irrevocable Letter of Credit
An irrevocable letter of credit is a guarantee from a bank, issued in the form of a letter. It creates an agreement where the buyer's bank agrees to pay the seller as soon as certain conditions of the transaction are met.
These letters help eliminate concerns that unknown buyers won't pay for goods they receive or that unknown sellers won't ship goods that have been paid for. This allows companies (and individuals) to do business with confidence.
- Alternate name: Irrevocable line of credit
- Acronym: ILOC
Letters of credit are often found in international trade, though they can also be used for domestic transactions. Irrevocable letters of credit cannot be changed or canceled without the permission of everybody involved (the buyer, the seller, and any banks involved), thus minimizing the risks that all parties take in the transaction.
How an Irrevocable Letter of Credit Works
An irrevocable letter of credit provides security to both parties in a transaction: the buyer and the seller. The buyer won't pay anything until goods have been shipped or services have been performed, and the seller will get paid as long as all of the conditions in the letter are followed.
The way in which an irrevocable letter of credit works can vary based on the details of the letter and the documents involved in verification. However, all letters of credit will have the same base elements.
- A guarantee of payment is made by a bank.
- It's made on behalf of a buyer (or applicant) to pay a seller (or beneficiary) an agreed-on amount of money.
- Specific documents are required verifying that goods/services have been supplied.
- Time limit, dates, locations, and how the transaction will take place are specified.
- All documents must comply with terms set out in the letter of credit.
Once the seller has shipped goods to the buyer, the seller must provide the specified documents to the bank to show that the shipment was made according to the terms of the letter. These documents are then sent to the seller's bank, which reviews them and issues a payment. The bank then provides the documents to the seller, including any necessary paperwork for claiming the shipment when it arrives.
A sell may be required to pay their bank at different points. For example:
- Seller provides funds upfront, which are then held at the bank until the transaction is completed.
- A seller with sufficient credit and collateral repays the bank after the transaction is complete.
- The bank issues a loan to the seller to cover the payment, which is then repaid over time.
Though using an irrevocable letter of credit facilitates the transaction between the buyer and seller, it does not eliminate all risk. The parties involved have to meet the requirements of the letter with 100% compliance for the transaction to proceed smoothly and for the seller to get paid.
If anything is off, the bank can refuse payment, including:
- Major problems, such as sending the shipment late; and
- Minor errors, such as typographical errors in the agreement or substituting the word "Suite" for "Unit" in the address
To avoid any problems with either shipment or payment, buyers and sellers should carefully examine the conditions laid out in the letter of credit to ensure that they can comply with all of them.
Do I Need an Irrevocable Letter of Credit?
When you do business with somebody in a foreign country (or even with a brand new customer or vendor in your home country), you have to trust them, even if you've never met the person you're dealing with or don't know much about their company. This can leave both buyers and sellers with significant concerns about payment and shipping. Irrevocable letters of credit can reduce these risks, allowing business transactions to move forward with minimal risks on both sides.
For sellers, letters of credit are especially beneficial, because the seller gets to rely on the strength of the bank, not the strength of the buyer. The bank will pay you as soon as you prove that you’ve met the conditions spelled out in the agreement, eliminating the need to assess the financial stability and trustworthiness of every potential buyer in a foreign country.
For buyers, letters of credit help ensure that something has actually been shipped. However, your bank will make payment once your seller provides documents showing that a shipment was made. You won't know what's in the shipment until it arrives. To manage risk, you can require that an inspection certificate be one of the required documents before payment can be made.
Alternatives to an Irrevocable Letter of Credit
If you're not sure whether an irrevocable letter of credit is the right choice for your business and the current transaction, you can look into alternatives, including:
- Trade credit insurance, which might be less expensive
- Different types of letters of credit
However, you should generally avoid revocable letters of credit, which can be changed without the agreement of everyone involved.
Sellers generally want letters of credit to be irrevocable to avoid producing and shipping goods without any guarantee of payment. But buyers may also want things set in stone: they don't want sellers to ship goods late or change order quantities without discussing things first.
Ultimately, however, the greatest risk in using a revocable letter of credit falls on sellers, who may find themselves responsible for the cost of both production and shipping with no recourse for being paid. Sellers should avoid any transactions involving a revocable letter of credit.
It is extremely difficult to find a letter of credit that is not irrevocable. However, it's always worth verifying whether or not you have an irrevocable or a revocable document.
How to Get an Irrevocable Letter of Credit
If you need to obtain a letter of credit, talk with your bank. You will likely work with a representative from the international trade (or similar) department.
Don’t try to craft a letter of credit yourself or adapt one that somebody else used. If any detail is off, you will risk an expensive legal battle, potentially overseas where laws may be different from what you’re used to. You could find yourself unable to claim goods you paid for or unable to receive payment for goods you have shipped.
Writing your own irrevocable letter of credit may seem like a way to save money, but it can quickly become expensive and damaging for your business. To get a letter of credit, always seek help from the bank that will be involved in your transaction.
- An irrevocable letter of credit is issued when a bank representing an importer agrees to pay the seller (the exporter) for an international transaction.
- The letter of credit reduces the risks taken by both buyers and sellers that foreign goods will be shipped, and payment made.
- The terms and conditions set forth in an irrevocable letter of credit are fixed and can only be changed with the express agreement of all parties involved.
- An irrevocable letter of credit should always be obtained from a commercial bank and not drafted by the importer or exporter.