IRREVOCABLE LETTER OF CREDIT: Definition, Example & How It Works

IRREVOCABLE LETTER OF CREDIT: Definition, Example & How It Works
IRREVOCABLE LETTER OF CREDIT: Definition, Example & How It Works

An irrevocable letter of credit helps eliminate concerns that unknown buyers will not pay for goods received or that unknown sellers will not ship goods paid for.  This allows companies (and individuals) to do business with confidence.

This letter is a bank guarantee issued in the form of a letter.  This creates an agreement whereby the buyer’s bank agrees to pay the seller once certain terms of the agreement are met.

What Is An Irrevocable Letter Of Credit?

Letters of credit are essentially agreements made between customers using each other’s banks.  The buyer’s bank guarantees payment to the seller’s bank to help start trade and commerce. 

For example, if a small business wanted to enter into a contract with an overseas supplier for a certain product, it would agree on the terms of sale, such as quantity, quality standards, and pricing, and then ask its respective banks to open a letter of credit for the transaction. 

The buyer’s bank then forwards the letter of credit to the seller’s bank, where payment terms are finalized and shipment is made.

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How Does Irrevocable Letter Of Credit Work?

A letter of credit is issued by a commercial bank that guarantees that the buyer’s payment to the seller will be received on time and for the correct amount.  In the event that the buyer is unable to make payment for the purchase, the bank will be required to cover all or the remainder of the purchase amount.

Due to the nature of international transactions, including factors such as distance, different laws in each country, and the difficulty of knowing each party personally, the use of letters of credit has become a very important aspect of international trade.

Although an ILOC is irrevocable as long as it is in effect, usually the period of time during which the proposed transaction is expected to be completed, the ILOC expires at a specific time specified in the letter of credit.

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Irrevocable Letter of Credit Example

To understand an irrevocable letter of credit, imagine that a Jordanian firm (hereafter the buyer) entered into a contract to purchase reinforced steel bars from a British firm which were to be delivered in two instalments.

The buyer asked the issuing bank to issue two letters of credit in favor of the seller, with of which one letter of credit was realized according to the delivery of the 1st tranche.

After which it was found that the batch of goods was not in accordance with the contracts and the buyer asked to stop the implementation of the 2nd letter of credit, where the court ruled that the confirmed letter of credit is a contract between the banker and the supplier, which obligates the baker to pay, regardless of the dispute between the parties or compliance of the goods with the requirements of the contract.

A similar verdict was handed down in another case where the court said that courts should not stop banks from enforcing letters of credit because it creates confusion and undermines confidence in banks.

From the above two statements, it can be concluded that the letter of credit cannot be stopped regardless of any reason, and payments to the seller are guaranteed.

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Difference Between Surety Bond Vs Letter of Credit

Surety Bond

Bond producers issue surety bonds on behalf of another party.  Surety bonds are third-party agreements and usually include the surety, the lender, and the principal. 

The principal must fulfill the obligation guaranteed by the guarantor, and the creditor benefits from this performance.  If the principal defaults, the bond protects the lender from the consequences of default and financial risk.  For example, warranty obligations protect suppliers from non-payment by contractors.

Three parties also participate in the letter of credit: the issuing bank, the seller and the buyer.  These official documents are issued by banks or financial institutions on behalf of buyers, guaranteeing that the seller will receive payment for the goods or services provided to the buyers. 

When the seller forwards the goods, he must submit the documentation as specified in the letter of credit to the issuing bank.  As an intermediary, the bank’s role is to verify that the documentation meets the terms of the letter of credit and then make payments.

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How To Get An Irrevocable Letter Of Credit

To get an ILOC, you need to contact your bank, who will provide you with a representative.  This representative has previous or similar experience in international trade and will work with you to fulfill your requirements.

Do not try to make an LC yourself or copy someone else’s.  This can lead to greater legal and financial complications in the future even in the case of a minor mistake.  You may also not be able to claim your items for which you have paid in full.

Writing an ILOC may seem like the right thing to do in the short term to save money.  However, this can quickly turn into an expensive affair and harm your business.  Therefore, we advise you to contact your bank for help.


Irrevocable Letter of Credit Cost

Bonds are project-specific and typically cost between 0.5 and 2 percent of the project cost.  In contrast, a bank letter of credit is usually for one year, and you typically pay the bank about 1 percent of the amount covered in fees. 

A surety usually covers 100 percent of the contract, while a letter of credit may only cover a portion of the contract – usually around 5 to 10 percent.

The total price of an ILOC is usually 1-2% of the contract amount.  The cost depends on the type of ILOC used, the customer’s credit history, tenure, security provisions and other factors.  The rate also depends on the chosen bank, as it will add a certain margin to the letter of credit.

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An ILOC is a means of facilitating a transaction between a buyer and a seller with the help of their respective banks.  The buyer requests an ILOC from their bank, which is then sent to the seller’s bank. 

In addition to providing protection against credit risk, an ILOC usually also specifies important details of the transaction, such as price, payment terms, and the time and place of delivery of the goods.  In the event that the buyer does not make the payment as agreed, the buyer’s bank makes a payment to the seller’s bank, which in turn makes a payment to the seller, the beneficiary of the ILOC.

ILOCs can also be confirmed or unconfirmed.  A confirmed ILOC provides additional risk protection for the seller by guaranteeing payment from both the buyer’s bank and the seller’s bank.  With an unconfirmed ILOC, the seller’s bank is not responsible for the payment and essentially only serves as an intermediary to transfer the payment to the seller from the buyer’s bank.

Irrevocable Letter Of Credit FAQs

Is Irrevocable LC Safe?

Yes, irrevocable ILOC is protected against all other forms of LC.  The contract cannot be amended or supplemented by one party without the prior approval of the rest of the parties involved and guarantees payment to the seller upon fulfillment of the requirements, which gives a sense of relief to both parties, the payment and the goods will be fulfilled as per the contract encouraging international trade.

What Are Surety Bonds Used For?

Surety bonds and letters of credit are used as risk management methods.  They guarantee payments in the event of non-fulfilment or non-fulfillment of contractual terms.  While bond producers must investigate all issues related to surety bonds, finance companies need only verify receipt and accuracy of documentation required by letters of credit. 

What Is An Unconfirmed Irrevocable Letter of Credit?

An unconfirmed irrevocable letter of credit involves the obligation of the issuing bank to pay, accept or negotiate the letter of credit.  The advising bank forwards the letter of credit to the beneficiary, without assuming any responsibility or obligations on his part, but confirming the authenticity of the document.



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