Letter of Credit vs. Line of Credit: Understanding the Differences

Letters of credit and lines of credit have different structures and purposes. A line of credit usually is established for ongoing use as long as the borrower continues to make monthly payments, while a letter of credit typically is used to guarantee payment in a single transaction between two businesses.

Line of Credit

A line of credit is a loan from a financial institution to either a business or individual that allows discretionary use of funds up to a specified limit. Credit lines usually are backed by collateral, and borrowers are charged interest by the lender on funds that have been accessed. The structure of a line of credit is similar to maintaining a debit balance on a credit card, in that the loan remains open-ended as long as required payments are made as scheduled. Secured credit lines, however, are different from credit cards because they carry the risk of the lender taking possession of the asset backing the loan if the borrower defaults on payments.

Uses of a Credit Line

Lines of credit are often used by businesses and individuals to cover income shortfalls from month to month, but can be used for a variety of purposes ranging from the purchase of business-related equipment to paying for a family vacation.

• Individual use. A common type of credit line for individual use is backed by the amount of equity in the home and is referred to a home equity line of credit., or HELOC. Homeowners can access funds by either writing checks or using a debit card linked to the credit line.

• Business use. A business might use a credit line to fund the bulk purchase of materials from different vendors at the beginning of a manufacturing cycle for a new product.

Letter of Credit

A letter of credit provides a guarantee of payment from a financial institution to a seller of goods or services. These documents are commonly used in transactions between companies located in different countries, but can be used for domestic deals as well. Generally speaking, a letter of credit involves three parties: the seller/beneficiary, the buyer, and the bank that has guaranteed payment. A fourth party, referred to as an advising bank, may be included in a letter of credit if the seller directs the payment to a financial institution. The payment to the seller can be made by either the buyer or the buyer's bank. If the bank makes the payment, the buyer usually provides reimbursement from deposits on account.

Example: Using a Letter of Credit

A manufacturer in the U.S. needs 1,000 customized widgets priced at $300 each from a new factory in China. To meet the specifications of the order, the factory must borrow $50,000 for equipment modifications. The transaction proceeds as follows:

1. Request a guarantee. Because the two parties have never done business before, the factory owner asks the buyer for a letter of credit to guarantee the full purchase price of $300,000.

2. Secure loan and establish advising bank. The factory's financial institution agrees to lend the factory the requested $50,000 as long as it is listed as the advising bank for the money guaranteed by the letter of credit.

3. Obtain letter of credit. The buyer gets a letter of credit from its bank, backed by the value of the buyer's accounts on deposit at that institution.

4. Make shipment and receive payment. After the order is completed and shipped, the advising bank provides the required documentation for payment to the buyer's guarantor, deducts the loan amount and associated fees upon receipt, and forwards the balance to the beneficiary.