A letter of credit (LC) is a bank's promise to pay a seller, the beneficiary, when the seller presents documents that match the credit's terms. U.S. federal rules describe letters of credit as independent undertakings. The bank's duty to pay depends on the documents, not on a dispute between the buyer and the seller (12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026). Letters of credit are governed by UCC Article 5 or by rules of practice such as the ICC's UCP 600 (12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026).
What is a letter of credit?
In simple words, the buyer's bank stands behind the payment. The seller ships, or performs, and then presents the documents the credit names. If the documents comply, the bank pays. If they do not, the bank may refuse. The underlying sale contract is a different promise from the bank's promise.
The parties
- Applicant. The buyer who asks the bank to issue the credit.
- Beneficiary. The seller who gets paid when the documents comply.
- Issuing bank. The bank that issues the credit and takes on the duty to honor a complying presentation.
- Advising bank. A bank that tells the beneficiary the credit exists. Advising is not the same as promising to pay.
- Confirming bank. A bank that adds its own promise to pay, so the beneficiary is not looking only to the issuing bank.
How a letter of credit works
- The buyer and seller agree that payment will be by letter of credit, and they name the documents.
- The buyer asks its bank to issue the credit in favor of the seller.
- The credit is advised to the seller, and confirmed if that was agreed.
- The seller ships or performs, and presents the documents.
- The bank examines the documents against the credit. A complying presentation is honored. A discrepant one can be refused.
- The buyer reimburses the issuing bank under their agreement.
An illustrative trade
This example is labelled as an illustration, not a real shipment. An importer in the United States buys goods from an exporter abroad. The importer is the applicant. The exporter is the beneficiary. The importer's bank issues an irrevocable credit that pays at sight against a commercial invoice, a transport document, and the other papers the credit lists. The exporter presents those papers. The bank pays if they match. No fee and no invoice amount are stated here, because this page does not cite a fee schedule.
Types of letters of credit
Commercial and standby
A commercial, or documentary, credit is used to pay for the goods in the ordinary course. A standby letter of credit is used when the applicant does not perform. The beneficiary draws on the standby by presenting the documents that show the default the credit describes.
Irrevocable, confirmed, sight, and usance
An irrevocable credit cannot be changed without the parties the credit protects. A revocable credit is rarely what a seller wants, because it can be withdrawn. A confirmed credit adds a second bank's promise. A sight credit pays when complying documents are presented. A usance, or time, credit pays at a later date the credit states.
Letter of credit, guarantee, and line of credit
| Letter of credit | Bank guarantee or standby | Line of credit | |
|---|---|---|---|
| When it pays | On complying documents, in the ordinary course for a commercial credit. | When the applicant fails and the beneficiary presents the required demand. | When the borrower draws. It is a loan, not a documentary promise. |
| What it follows | The credit's document list, independent of the sale dispute. | The guarantee or standby terms. | The loan agreement and any borrowing base. |
A surety bond is a further different contract, with a surety rather than an issuing bank under UCC Article 5. This page does not restate surety law.
Rules that govern letters of credit
National banks may issue letters of credit under 12 CFR 7.1016. The rule treats them as independent undertakings. It points to UCC Article 5 and to rules of practice such as UCP 600 and ISP98 as the frameworks those undertakings use (12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026). UCP 600 is the ICC's uniform customs for documentary credits. ISP98 is the institute's rules for standby letters of credit. The credit itself says which rules apply. This page does not quote those rulebooks beyond what 12 CFR 7.1016 identifies.
Costs and risks
Banks charge fees for issuance, confirmation, and amendment. This page does not state a percentage or a dollar fee. No fee schedule is cited. The practical risk for the seller is a discrepancy: a document that does not match the credit can delay or prevent payment. The practical risk for the buyer is paying against documents that comply on their face even if the goods are later disputed, because the undertaking is independent of that dispute (12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026).
Why letters of credit matter for receivables
The document check is literal. The bank compares the papers to the credit. A name that does not match, a shipment date the credit does not allow, or a missing signature the credit required are the kinds of discrepancies banks refuse. This page uses those as illustrations of the idea of a discrepancy. They are not a case, and they are not a holding. The credit's own list controls.
The buyer should read the credit before the goods ship, because a discrepancy is expensive to cure after the documents are on their way. The seller should read it before accepting the credit, because the seller is the one who has to produce the papers. An amendment is a change to the credit. Who must agree to an amendment depends on the credit and the rules it incorporates. This page does not restate that consent rule beyond pointing at 12 CFR 7.1016 and the practice rules it names (12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026).
Revocable and irrevocable credits are not equal promises. A seller who needs the bank's promise to stay in place asks for an irrevocable credit. A confirmed credit adds another bank, which matters when the seller does not want to rely only on a bank in the buyer's country. Sight and usance change when cash arrives, not whether the documents must comply. A usance credit can still be refused if the documents do not match.
A letter of credit is not a line of credit the seller can draw at will. It is not a surety bond. It is not a guarantee that the goods are sound. It is a promise to pay against the papers. UCP 600 is the ICC rule set many commercial credits name. ISP98 is the standby rule set. The credit should say which one applies (12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026).
Walk the illustrative import once more, without adding a price. The importer asks its bank to issue the credit. The exporter receives advice of that credit. The exporter ships and presents the invoice and the transport document the credit named. The bank pays if those papers comply and refuses if they do not. The importer reimburses its bank. The exporter's open invoice is collected when that payment arrives, which is why the credit matters to receivables. No fee is stated, because no fee schedule is cited.
An advising bank passes the credit along. A confirming bank adds its own promise. If your credit has only an advising bank, you still look to the issuer for payment. Read the credit to see which bank, if any, confirmed it.
Standby credits use the same independence idea and a different moment of payment. The beneficiary draws because the applicant did not perform, and the documents are the ones the standby lists for that default. Do not describe a standby as a commercial credit that pays for the goods in the ordinary course. The table above keeps those moments apart.
An export invoice is an account receivable until it is paid. A complying letter of credit moves the payment risk from the foreign buyer to the issuing bank, within the document rules. It does not remove the need for a credit policy. See credit control and accounts receivable. A different receivables product is invoice factoring, and a secured loan against receivables is asset-based lending. Commercial credit research is filed at commercial credit and receivables and credit.
FAQ
What is a letter of credit in simple words?
It is a bank's promise to pay the seller once the seller presents the documents the credit requires.Who are the parties to a letter of credit?
The applicant (buyer), the beneficiary (seller), the issuing bank, and often an advising bank or a confirming bank.What is the difference between a letter of credit and a bank guarantee?
A commercial letter of credit pays on complying documents in the ordinary course. A guarantee or standby pays if the applicant fails to perform.Is a letter of credit a loan?
No. It is an independent payment undertaking. The applicant reimburses the bank under their agreement (12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026).What rules govern letters of credit?
12 CFR 7.1016 treats them as independent undertakings and identifies UCC Article 5 and rules of practice such as UCP 600 and ISP98 (12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026).Sources
- 12 CFR 7.1016, independent undertakings, Title 12 as of October 22, 2026 Accessed October 26, 2026.