In layman’s terms, a bank guarantee and a letter of credit may seem similar. However, in the finance world, these two terms are actually different from one another. Because they are often confused, it is no longer a surprise why there are many people who are shocked to learn that they are different from one another.
In a nutshell…
Letters of credit ensure that a transaction goes successfully as it was originally planned. Meanwhile, bank guarantees minimizes losses once transactions don’t go as planned. Because they are somewhat similar, it is easy to interchange the two and be confused about what they truly are.
What is Letter of Credit?
By definition, a letter of credit is a binding document which buyers can request from the bank as a guarantee that payment for goods purchased will be transferred to the seller. The letter serves as a reassuring letter that the seller will receive payment due to him. The payment will only occur once the seller presents the necessary shipping documents to the bank. This will serve as confirmation that shipment of the goods to the buyer was completed in the given time frame.
Because of the method used, letters of credit are often used in international transactions in order to reduce the risks. These risks include unfamiliarity with the foreign country, political instability, or the customs department.
A letter of credit can also be defined as an obligation given to a bank so that a criteria can be followed before payment is made. As soon as the terms from both parties have been confirmed and completed, it is now the bank’s role to transfer the funds.
A letter of credit ensures payment for performed services.
What is Bank Guarantee?
Just like a line of credit, a bank guarantee is being used to insure a sum of money to its beneficiary. It is actually a type of guarantee wherein a bank or another lending organization makes the promise to repay their debtor’s liabilities in the event that he is unable to do so.
This is the big difference between the two financial terms. While the former is given by the debtor, a bank guarantee is only paid once a person is unable to fulfill his or her stipulated obligations under the agreement. As such, it is only used to insure both parties from loss or damage as a result of nonperformance from the other party involved in the agreement.
How Do These Help You?
A letter of credit can be used upon the completion of a service or delivery of goods. Before the transaction occurs, the seller can send a request to the bank to obtain a letter of credit. The buyer will purchase the letter of credit from the bank and forward it to his seller’s bank. As such, the letter will act as a replacement or substitute for the credit of the client, so that correct and timely payment is assured.
A bank guarantee can be used if a buyer obtains goods or services from a seller and then encounters cash flow difficulties. As a result, he is unable to pay his seller in time. A bank guarantee is suitable in such instances because it would pay an agreed-upon amount to the seller. Alternatively, if the seller is unable to provide the goods, a bank will pay his buyer the agreed-upon sum. For any side of the transaction, the bank guarantee serves as an extra safety measure.
Thanks to these two types of transactions, individuals are able to participate in international trade with customers around the world. Because of these options, the risks are lessened. It also helps build the mutual trust between the two parties involved in the trade.
Have you ever used a letter of credit or a bank guarantee? In what circumstances?