A letter of credit, or simply a credit letter, is a trading instrument issued by banks to confirm the trade payment terms between buyer and seller.
The letter of credit of LC is required when buyers and sellers operate in different statuary or place large orders that require payment confirmation.
Usually, a letter of credit is required in an international trade deal between an importer and an exporter.
Both parties can avail of the LC facilities to secure the contract completion. Exporters are usually keen to receive the LCs as they risk the shipment of goods.
Similarly, the importer risks advance payments and a delayed or poor quality of imported goods.
The bank plays the role of a facilitator by issuing credit letters.
Depending on trade contract terms, the letter of credit may take several forms. The most commonly used LC is irrevocable; however, many applicants use revocable LCs too.
A Revolving Letter of Credit is a bank-issued trade instrument that allows multiple withdrawals from a letter of credit facility issued.
A revolving LC allows multiple amounts to withdraw, meeting certain conditions and terms as agreed upon by both parties in the trade contract.
However, unlike other LC facilities, the revolving LC doesn’t require re-approvals from the bank up to a certain time or amount.
How does a Revolving Letter of Credit Work?
Importers and exporters enter the trade contracts through bank guarantees such as LC and LG.
Over time they develop trade relations and require continuous trade deals. Some trade deal orders are shipped in a series of multiple shipments.
The applicant of LC usually gets approved a large amount of LC for the full trade value but wishes to release the payments as it receives shipments.
This is where the revolving credit facility becomes effective for importers and exporters.
- The credit amount is renewed or reinstated without specifically changing the LC terms.
- The Revolving LC can be termed on time and value of the contract basis
- The applicant can control the payments by adding time or value clauses from the total LC facility
As with any other type of Letter of Credit, a revolving LC can be revocable or irrevocable. However, the prime utility of the revolving LC is that it can be issued on a time or value basis.
Time-Based Revolving Letter of Credit:
The applicant avails the Letter of Credit facility from the bank in full. In a time-based revolving LC, the terms are set for shipments received against a specified time.
The applicant includes the clause of regular payments to the exporter or seller for a series of payments.
Usually, the payments are monthly or quarterly, depending on the frequency of the shipments received.
For example, one country’s importer of Techno Blue may wish to make regular monthly payments to its seller in another country for the next 12 months.
Let’s say the LC facility is $120,000, but the revolving LC facility allows making $10,000 monthly payments.
Cumulative Revolving Letter of Credit:
If the revolving credit facility is cumulative, it can adjust the payments of the remaining goods in the following months.
For example, if the buyer receives less than the agreed $ 10,000 inventory, the seller must cover goods shipments in the next months. It allows greater flexibility in the trade deal but is a risky option for the buyer.
Non-Cumulative Revolving Letter of Credit:
The buyer may wish to reduce the risk by making revolving LC non-cumulative. It bounds the seller to ship the required goods in time with certain terms and conditions.
Any remaining balance due to a supply shortage cannot be carried over to the next period.
Value-Based Revolving Letter of Credit:
This facility works similarly to that of a Time-based revolving LC. The only difference is the release clause becomes dependent on the value of the goods.
In this facility, the LC payments can only be released if the buyer receives the agreed minimum value of the goods. It bounds the seller or exporter to manufacture regularly.
Benefits of Revolving Letter of Credit Facility:
A revolving LC facility is used where the seller and the buyer make regular and consistent trade transactions.
- It saves time and cost for the LC applicant as the facility can be reissued without specific changes.
- It can facilitate regular and consistent trade from a regular supplier
- It offers flexibility and trust between the buyer and seller
- It motivates the sellers to manufacture consistent levels if the buyers opt for non-cumulative revolving LC.
Limitations of Revolving Letter of Credit Facility:
The revolving LC provides great flexibility to both buyers and suppliers. In practice, it is used widely due to the changing nature of trade contracts and customs regulations.
- The revolving LC facility works well with regular and consistent suppliers only.
- It cannot be used with a one-time trade agreement.
- Frequent changes in Customs, taxes such as VAT, and product designs require frequent amendments in the trade deals, hence payments through LCS.
Does a Revolving Line of Credit Affect Credit Score?
Yes, a revolving line of credit can significantly impact your credit score, both positively and negatively.
For example, if you make your payments consistently on time and don’t exceed the set limit, it can help increase your FICO® score.
However, if you miss payments or borrow more than you should, it can cause serious damage to your credit score.
One common misconception is that a line of credit is a loan – but they’re quite different. With a loan, borrowers receive funds upfront that must be repaid in full over the life of the loan with interest attached.
With revolving lines of credit, however, borrowers are only charged interest on what has been borrowed from the lender in any given month, not on the entire amount available to borrow.
This also means that lenders can increase or decrease the amount available for borrowing as needed without affecting your payment plan.
Additionally, unlike loans which often come with fixed repayment periods and terms, lines of credit typically stay open until the borrower has paid all of their debt back to their lender – meaning any new purchases or expenses automatically get billed in addition to what’s already owed until everything is paid off.
It’s important to remember that every lender has rules and regulations when granting lines of credit.
Be sure to research before signing up for one, so you understand all the potential implications this could have on your finance’s overall credit score.
What is An Irrevocable Letter of Credit? How is it Different from a Revocable Letter of Credit?
An irrevocable letter of credit (LC) is a document issued by a bank or financial institution to guarantee payment between two parties.
When an LC is opened, the issuer guarantees that the beneficiary will receive payment for goods purchased by the customer so long as their requirements are met.
This can be helpful when dealing with overseas suppliers, who may require additional security before shipping goods since pursuing payment is challenging if something goes wrong during the transaction.
The difference between an irrevocable and revocable LC lies in the terms and conditions outlined in the document.
An irrevocable LC cannot be changed or canceled without both parties agreeing to do so in writing and often requires third-party mediation for any amendment or cancellation requests to take place.
On the other hand, a revocable LC can be modified or rescinded at any time should either party choose to do so without requiring any notification.
In summary, an irrevocable LC provides greater security than a revocable one as it eliminates potential miscommunication between parties while allowing buyers to deal with international suppliers without worrying about non-payment issues arising due to changes or cancellations.