Letter of Credit (LOC)
What is it
An LOC is a standing amount of money, similar to a loan, that a bank extends to a customer. A customer may draw upon the available line of credit, provided that the amount does not exceed the limit. Money borrowed on the line of credit must be paid back within a specified timeframe, at a specified interest rate. Unlike a loan, however, only the money actually drawn (or used) on a line of credit is charged interest. For instance, if someone has a 20k line of credit from his bank, but draws only 5k, he will be changed interest on only the 5k.
All LOCs consist of a set amount of money that can be borrowed as needed, paid back, and borrowed again. The amount of interest, size of payments, and other rules are set by the lender. Some lines of credit allow you to write cheques (drafts) while others include a type of credit or debit card. As noted above, an LOC can be secured (by collateral) or unsecured, with unsecured LOCs typically subject to higher interest rates. A line of credit has built-in flexibility, which is its main advantage. Unlike a closed-end credit account, a line of credit is an open-end credit account, which allows borrowers to spend the money, repay it, and spend it again in a never-ending cycle.
Bank Guarantee v Letter of Credit
It is important to note that a bank guarantee is not the same as a letter of credit, although with both instruments the issuing bank accepts a customer’s liability if the customer defaults.
With a guarantee, the seller’s claim goes first to the buyer, and if the buyer defaults, then the claim goes to the bank. With letters of credit, the seller’s claim goes first to the bank, not the buyer. Although the seller will likely get paid in both cases, letters of credit offer more assurance to sellers than guarantees generally do.
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