Letter of Credit vs. Documentary Credit: What's the Difference?
Edited by Aimie Carlson || By Janet White || Published on February 2, 2024
A letter of credit is a bank guarantee for payments in international trade, while a documentary credit is a specific type of letter of credit involving documents.
Key Differences
A letter of credit is a financial tool used in international trade where a bank guarantees a seller's payment, provided specific terms are met. Documentary credit, a subset of letters of credit, specifically involves the exchange of documents, such as shipping and insurance documents, to fulfill the terms of the credit.
In a letter of credit, banks act on behalf of buyers to ensure payment security for sellers, reducing the risk of non-payment. Documentary credit emphasizes the importance of documents in these transactions, ensuring that all terms of the sales agreement are strictly adhered to and verified through documentation.
The scope of a letter of credit can vary, covering various types of trade transactions and financial arrangements. Documentary credit is more specific, always requiring the presentation of certain documents to trigger payment, such as bills of lading or commercial invoices.
Letters of credit can be revocable or irrevocable, providing flexibility or security in transactions. Documentary credits are typically irrevocable, offering a high level of security and certainty in international trade.
Both tools are essential in international trade, facilitating trust and smooth transactions between parties in different countries. While a letter of credit offers a broad guarantee, a documentary credit provides a detailed, document-based framework for this guarantee.
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Comparison Chart
Definition
Bank guarantee for payment
Specific type of letter of credit with document exchange
Emphasis
Payment security
Document verification for payment
Scope
Varied trade transactions
Specific, requiring certain documents
Types
Can be revocable or irrevocable
Typically irrevocable
Function in International Trade
Facilitates trust in transactions
Ensures adherence to sales agreement terms
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Letter of Credit and Documentary Credit Definitions
Letter of Credit
A financial tool mitigating risk in international transactions.
To reduce risk, the company used a letter of credit for their overseas purchase.
Documentary Credit
Ensures adherence to precise terms in trade agreements.
The documentary credit ensured strict compliance with the sales contract.
Letter of Credit
Facilitates international trade by guaranteeing payments.
Letters of credit have streamlined global business dealings.
Documentary Credit
Involves detailed document verification for payment.
Payment was released under the documentary credit after document verification.
Letter of Credit
Can be revocable or irrevocable, depending on the agreement.
The contract specified an irrevocable letter of credit for added security.
Documentary Credit
Used in international trade to validate transaction terms.
Documentary credit was crucial in our complex export deal.
Letter of Credit
Ensures payment upon fulfillment of agreed terms.
The letter of credit was honored once the shipment arrived.
Documentary Credit
A letter of credit requiring specific documents for payment.
Our documentary credit required the presentation of shipping documents.
Letter of Credit
A bank guarantee ensuring payment to a seller in international trade.
The exporter requested a letter of credit to secure payment.
Documentary Credit
Typically irrevocable, offering security in transactions.
The irrevocable documentary credit provided certainty in our international trade.
FAQs
How does a letter of credit reduce risk?
It guarantees payment to the seller, reducing the risk of non-payment.
What documents are involved in documentary credit?
It typically involves shipping, insurance, and commercial documents.
What role do banks play in documentary credit?
Banks ensure that all required documents are presented before releasing payment.
Can a letter of credit be canceled?
A revocable letter of credit can be canceled; an irrevocable one cannot.
Who benefits from a letter of credit?
Both the buyer and seller in international trade benefit from it.
What is the key purpose of documentary credit?
To provide a secure framework for payment based on verified documentation.
What is a letter of credit?
A bank guarantee that ensures payment to a seller in international trade.
What is documentary credit?
A specific type of letter of credit involving the exchange of documents.
When is a letter of credit used?
It's used in international trade to facilitate trust and ensure payment.
Is documentary credit always irrevocable?
Documentary credits are typically irrevocable, providing more security.
How does documentary credit ensure sales agreement adherence?
It requires the presentation of specific documents that verify contract compliance.
What is the significance of document verification in documentary credit?
It ensures that all terms of the trade agreement are met before payment is made.
Can any bank issue a letter of credit?
Most banks that handle international transactions can issue it.
What happens if the terms of a documentary credit are not met?
If terms are not met, the bank will not release the payment.
Are there different types of letters of credit?
Yes, including commercial, standby, and others, each with different purposes.
Can a letter of credit be modified?
An irrevocable letter of credit cannot be modified without all parties' consent.
Is a letter of credit legally binding?
Yes, it is a legally binding document.
Who issues a letter of credit?
It is issued by a bank or financial institution.
Are letters of credit commonly used in international trade?
Yes, they are a common and trusted method for securing payments.
Does documentary credit speed up international transactions?
It can streamline transactions by providing a clear set of document-based criteria.
About Author
Written by
Janet WhiteJanet White has been an esteemed writer and blogger for Difference Wiki. Holding a Master's degree in Science and Medical Journalism from the prestigious Boston University, she has consistently demonstrated her expertise and passion for her field. When she's not immersed in her work, Janet relishes her time exercising, delving into a good book, and cherishing moments with friends and family.
Edited by
Aimie CarlsonAimie Carlson, holding a master's degree in English literature, is a fervent English language enthusiast. She lends her writing talents to Difference Wiki, a prominent website that specializes in comparisons, offering readers insightful analyses that both captivate and inform.
