Why is a letter of credit important?

By | May 13, 2008

Guidelines for letters of credit are set up in Article 5 of the Uniform Commercial Code. Letters of credit are important for business entities and individuals alike. When a business is attempting to purchase goods, services and technology to serve their clients, a letter of credit is essential. Most businesses do not pay cash or write a check for large purchases. When contacting new vendors, the letter of credit allows the vendor to see that the business is credit worthy and pays their bills in a timely manner. The vendor can then take on very little risk in forwarding the goods or services to the business organization without obtaining payment up front.

The letter of credit also, at times, guarantees the seller that the money will be received even if the purchasing business defaults – a guarantee of funds. The same goes for a person who wishes to know how much of a mortgage they can afford before searching for a new home. The bank reviews the potential buyer’s financial situation and issues a letter of credit to a potential seller or real estate agent that the buyer is indeed credit worthy and not wasting everyone’s time touring homes, requesting information and asking questions. In this manner, the seller and agent are assured that should the buyer be truly interested in making a purchase, the bank will back them up with a mortgage and help them obtain the necessary funds.

One thought on “Why is a letter of credit important?

  1. nratlos

    The view regarding the UCC Article 5 is rather US centric and does not apply to international trade. International trade is commonly effectuated according to the Uniform Customs and Practices (“UCP”) of the international Chamber of Commerce (Paris, France). This is similar to the INCOTERMS which are mentioned in the UCC, in international trade however, the INCOTERMS as published by the ICC are referenced.

    The INCOTERMS and the UCP are not laws and have to be included by reference into the contractual relationships between buyer./.seller, or applicant./.bank. They are usually modified every ten years and thus can adjust to technical or other developments faster than any politician.

    Currently, the UCP 600 are used, the number 600 desinating the ICC publication No. 600. Substantively the UCP 600 do not differ much from the UCP 500 an article by article commentary you can find at
    Letter of Credit Forum under the articles section.

    The site also offers of course a forum to ask questions, news, articles (eg on the UCP 600), sample documents and others.

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