What is the difference between the Bank Guarantee and Letter of Credit? This is the most common question that people involved or dealing with national or international trade have been struggling with for a very long time. And this is not surprising at all. Both of these terminologies look similar and provide similar benefits to buyers and sellers. A bank guarantee and letter of credit both are promises from a bank or financial institution that the sellers would be paid on-time with the full amount in exchange for their services regardless of the financial capabilities of the buyer. In both of these concepts, the bank guarantees and assures the third-party that if the buyers are not capable of repaying, the bank will pay it on behalf of them.
Whenever any businessman wants to deal with import-export business or expand his business in the different corners of the world, he needs assurance from the buyer to get paid on-time after delivery of goods or services. This is done by banks both in case of national and international business but the main difference is that bank guarantees are often used in real estate and infrastructure to reduce the credit risks in domestic markets whereas
Letter of Credits is used in other commodity international markets.
To understand the difference between these two, we must understand their definition first. Here we go:
What Is a Bank Guarantee/ Standby Letter Of Credit?
As the name suggests, in these services, a bank gives the guarantee to the beneficiary (Third-party) on behalf of its customer to pay the full-amount on-time in the event of default by its customer ie. buyer. It is a commercial instrument that takes place in public tenders or government-related works in the domestic market. So the bank guarantee has the same functions but in different ways. It is used in mitigating the risks in real estate and infrastructure projects.
Types of Bank Guarantee
- Financial Guarantee
- Performance Guarantee
What is a Letter of Credit?
A letter of credit is a financial instrument issued by the buyer’s bank to the seller to assure on-time payment after the terms and conditions mentioned in LOC are met by sellers. Every letter of credit has certain terms and conditions which are required to be fulfilled by both buyers and sellers for executing the transaction successfully. Here the sellers get guaranteed payment of their sale of goods from the buyer’s bank in case of international trade.
Types of Letter of Credit
- Commercial
- Revocable
- Irrevocable
- Confirmed
- Unconfirmed
- Back-to-Back
- Red Clause
- Transferable
- Un-transferable
Key Points Of Differences Between Bank Guarantee And Letter Of Credit:
Basis | Letter Of Credit | Bank Guarantee |
Boundary | It takes place in international markets. | It takes place in domestic markets. |
Protection | It also protects both the parties but favors sellers. | It protects both the parties but favors buyers. |
Parties Involved | 5 or more | 3 |
Industry Type | It is used by merchants in international markets | It is used by parties involved in real estate and infrastructure developers. |
Bank Liability | Primary | Secondary |
Preference | It gives preference to the fulfillment of the terms and conditions of LOC | It becomes effective only when there is a default made by the buyer in making payments |
Payment Time | Bank only pays when the Terms and conditions are met by both the parties | Bank makes payment when the contractual obligations are not fulfilled |
Frequently Used In | Import and Export Business | Government-related work |
Other Points Of Differences:
- A letter of credit issued by the buyer’s bank to the seller’s bank is an acceptance of the invoices presented by the seller and a guarantee to make payment after the fulfillment of terms and conditions of the agreement. Whereas in the bank guarantee services, the guarantee given by the bank to the beneficiary on the behalf of the applicant will only be effective if there is a default made.
- In a letter of credit, the bank bears the risk of the primary liability where it collects payment from the client afterward anyhow but on the other hand, the banks stand secondary as it will pay only when the buyer is not capable to do so.
- In the case of international trade, the involved merchants in the import and export of goods will consider letters of credit to ensure delivery and payment due to foreign countries and distance issues. In contrast, the contractors who are bidding for real estate or infrastructure projects will ensure their financial credibility through a bank guarantee.
Final Words
A letter of credit is used when there is a high level of risk involved in business globally but with the time, it is also being used in domestic trade. In simple words, it does not matter whether it is a domestic or international market, the buyer always wants to make sure on-time delivery of goods while an assured payment is a seller’s right. Both instruments are there to reduce your risks.
