Money is the medium of exchange in the form of coins or banknotes. It is indeed used to make the payment for goods and services, and also to buy things and pay debts and so on. The business world functions and revolves around money.
Among buyers, sellers, loan borrowers, and the financial institution or bank, Letter of Credit and Line of Credit play their respective important roles. A letter of credit and line of credit seem the same when hearing the words but both have different meanings and functions. The person who runs a business or an individual must know the difference between the letter of credit and the line of credit.
Letter of Credit vs Line of Credit
The main difference between the letter of credit and line of credit is that a Letter of credit is a document issued by the bank to the seller on request of the buyer. Whereas the line of credit is a financial instrument that helps the customer to borrow a maximum amount from the bank.
Letter of credit is a financial document that bank or financial institution issues to the sellers on request of the buyers. Compare to the line of credit its a very different instrument.
Line of credit is an instrument between the financial institution and the borrower, it fixes the maximum amount a person can borrow at any time.
Comparison Table Between Letter of Credit and Line of Credit (in Tabular Form)
| Parameter of Comparison | Letter of Credit | Line of Credit |
|---|---|---|
| Usage | A letter of credit ensures that the payment is done promptly to the seller from the buyer’s end. | Line of credit is the financial instrument that supports the business or an individual with financial loans. |
| Flexibility | It’s rigid, it can be used only once to make payment to the seller from buyer | It is flexible, the fixed amount can be used by the customer to borrow any time |
| Fees and Rated | There is a fixed fee by bank for a letter of credit and there is no need of paying any kind of interest | Line of credit fee is fixed along with fees borrower has to pay interest only for borrowed funds. |
| Parties involved | In the entire context of the letter of credit, 4 entities are involved; buyer and seller and their respective 2 banks | There are only two parties are involved in the process, borrower or customer and financial institution or bank |
| Geography | Letter of credit mainly used in international trade or globally where buyer and sellers are from different countries | Compare to the letter of credit, line of credit is used locally where customer and bank resides. |
What is Letter of Credit?
A letter of credit is a financial document or an instrument that the financial institution or the bank issues to the sellers on the request of the buyer. A letter of credit is mainly used in international trade, where buyers and sellers are from different countries.
A letter of credit also guarantees that the buyer will make the payment on time once the seller shows the proof of shipping and other documents of goods and services. In case of buyer fails to make a payment towards the seller then the bank will pay.
A letter of credit is used to avoid credit risk. The purposes of the letter of credit are, where the supplier has an assurance that the buyer will make payment after shipping the goods. Without a Letter of credit, a supplier may think that buyer will not make the payment after shipping, and the buyer may think that in case of advance payment seller can run away with the money without shipping goods. Both sellers and buyers think about their losses.
To have a smooth business and professional relationship among buyer and seller letter of credit is needed. And if the buyer has opened the letter of credit in the name of the seller, he can pay only to the mentioned name. In case if the buyer wants to pay others then he cannot do that.
As mentioned above financial institution collects fees for the letter of credit depending on the size of the letter of credit. There are several types of letters of credit available for international trade. They are:
- A commercial letter of credit
- Revolving letter of credit
- Traveller’s letter of credit
- Confirmed letter of credit
Letter of credit normally provided within two business days. Guaranteeing the payment from the buyer end if it fails then from the bank.
What is Line of Credit?
Line of credit is an instrument between the financial institution and the customer or borrower, the maximum loan can the customer borrow by using the line of credit at any time up to fixed amount decided by the financial institution for business or day to day life activity.
Line of credit is used for different purposes, the borrower or customer can use the line of credit to purchase, invest in the business, day to day activity, or spend without paying the immediate amount. Line of credit involves the fees fixed by bank and interest only to borrowed funds.
Line of credit has the flexibility of using whenever customer or borrower wants. The borrower can use a line of credit to pay the utility bill, creditors and purchase of material, goods, invest in the business, and can spend for his purposes up to a fixed amount decided by the bank.
In the line of credit, only two parties will be involved customer and financial institutions. There are two types of lines of credit, they are secured line of credit and unsecured line of credit.
Most of the lines of credits are unsecured. Where the borrower borrows the loan from the financial institution without promising any collateral. Unsecured loans are higher in interest and it affects the credit points. A credit card is one such of a line of credit.
A secured line of credit is involving interest rate and get the maximum credit limit. Where individual and business people more attracted to the secured line of credit as it provided maximum credit.
Line of credit is considered as the revolving account where the financial institution allows the borrower to spend money repay with interest and again spend, it is a never-ending cycle where revolving. Line of credit and credit card are different from the installment loans.
Line of credit has different types of forms where each follows under the secured or unsecured line of credit. They are
- A personal line of credit
- Home equity line of credit
- Demand line of credit
- Securities – a backed line of credit
- A business line of credit
The advantage of a line of credit is to borrow the fund only need and avoid paying the higher interest and misuse of the line of credit can hurt credit scores of the borrower.
Main Differences Between Letter of Credit and Line of Credit
- The main difference between the letter of credit and line of credit is a Letter of credit is a document issued by the bank to the seller and it is issued upon the buyer’s request. Whereas the line of credit is a financial instrument used by the customer to borrow the maximum amount at any time up to the amount fixed by the bank.
- Letter of credit used to make payment to the seller by the buyer in an international trade transaction. Whereas the line of credit used by the customer to borrow loans from bank to business or personal reason.
- Letter of credit is rigid; it can be used only once to make payment to the seller from the buyer and it can be only paid to a person in the name letter of credit issued. Whereas the line of credit is flexible, the fixed amount can be used by a borrower at any time.
- There is a fixed fee by bank for a letter of credit and there is no need of paying any kind of interest. Likewise, Line of credit fee is fixed along with fees borrower has to pay interest only for borrowed funds.
- In the letter of credit four parties are involved in the process. They are Buyer, the buyer’s bank. Seller and seller’s bank. Whereas In the letter of credit four parties are involved in the process. They are Buyer, the buyer’s bank. Seller and seller’s bank.
Conclusion
Letter of credit and Line of credit sounds similar when hearing about this but both have different meanings and functions. Letter of credit mainly used globally for international trade among buyers and sellers to make payment. A letter of credit helps businesses to have a healthy and professional relationship between buyer and seller.
Line of credit is an instrument; financial institution provides to its customer. The main advantage of the line of credit is the borrower can borrow money from a financial institution only how much he needed. Because of this, he can avoid paying higher interest. A credit card is one of the lines of credit that banks provide. In the case of a misuse line of credit, there is a chance of hurting borrower credit scores.
Both letters of credit and line of credit have it is own advantages and disadvantages, before using any services contacting financial institutions is good.
References
- https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=4155&context=lcp
- https://www.jstor.org/stable/838450
- https://repository.law.umich.edu/cgi/viewcontent.cgi?article=2776&context=mlr