Letters of credit and lines of credit are completely different things. The main difference is that a letter of credit is a guarantee from a bank or another financial institution that a vendor will get paid if certain conditions are met and a line of credit is an account that allows you to borrow money when you need it up to a predetermined limit.
The terms line of credit and letter of credit sound similar, which may lead to some people using them interchangeably. In fact, although both products are offered by financial institutions, they work entirely differently and have different purposes. Both lines of credit and letters of credit can help businesses make purchases but in very different ways. And while lines of credit are also available to individuals, letters of credit generally aren’t.
In this article, we’ll explain how lines of credit and letters of credit work and the key differences between them to help you determine which you might need.
What is a line of credit?
A line of credit is a type of revolving debt that allows a borrower to spend up to a specific amount from a lender. Unlike a loan, the borrower doesn’t receive a lump sum. Instead, they can borrow from the line of credit as needed and must only make payments on the portion of the line of credit they’ve used.
As we mentioned, lines of credit are revolving. Think of your credit card — you can use it each month, and as long as you pay back what you’ve spent, you can use the same credit again and again. A line of credit is similar, where borrowers can reuse the same credit, up to their line of credit, as long as they continue to repay what they’ve spent.
Personal lines of credit
Lines of credit can be used by both individuals and businesses. Individuals can take out personal lines of credit, which are unsecured, similar to personal loans. These credit lines are likely to have higher interest rates because of the increased risk to the lender. Individuals can also take out lines of credit that are secured by assets. For example, a home equity line of credit (HELOC) is secured by a borrower’s home.
Business lines of credit
Businesses also use lines of credit, often to manage their short-term cash flow or purchase the materials needed to produce goods.
What is a letter of credit?
A letter of credit, also known as a credit letter, is a document from a bank or financial institution that guarantees the payment from one party to another. Businesses use letters of credit, often in international transactions when they are buying goods from another country.
A letter of credit involves four parties. These are the business that’s buying the goods, the business that’s selling the goods, the bank or financial institution that writes the letter of credit, and the financial institution that represents the seller.
The credit letter provides reassurance to the seller because it states that if the buyer is unable to make the payment, the financial institution will make it on their behalf. And in many cases, the institution or bank pays the seller or seller’s bank or institution directly on behalf of the buyer. Unlike unsecured loans or lines of credit, the buyer’s institution usually requires collateral from the buyer, along with a fee.
Differences between a line of credit and a letter of credit
It’s probably clear from the descriptions above that lines of credit and letters of credit are very different products. Below we’ll go into further detail about some of the key differences.
The primary purpose of a line of credit is to provide liquidity to an individual or business. However, there are many reasons someone might open a line of credit.
In the case of an individual, someone might open a line of credit for a few reasons. A credit line can serve as an emergency fund of sorts, to consolidate high-interest debt, or to make a large purchase such as college tuition, home renovations, and more.
For businesses, lines of credit often help to provide liquidity for short-term cash flow. The business may use the line of credit to purchase materials and pay its bills, but regularly pay off the credit line to continue using it each month.
Letters of credit, on the other hand, usually correspond to a particular purchase. They are frequently used in international transactions. It assures the seller they’ll be paid for the transaction, so they may be more likely to make the sale.
Both lines of credit and letters of credit come in several different forms. The three most common types of lines of credit are personal lines of credit, HELOCs, and business lines of credit. Both personal lines of credit and HELOCs are available to individuals. The key difference is a HELOC is secured by someone’s home, while a personal line of credit is often unsecured.
A business line of credit is similar to a personal line of credit, but for a business instead of an individual. However, a financial institution may require that a business pledge collateral to open a line of credit.
There are also different types of letters of credit, four in total: commercial, standby, confirmed or unconfirmed, and revolving.
- Commercial. A commercial letter of credit is the most common type, where a financial institution writes the letter on behalf of a business and directly makes the payment to the seller.
- Standby. A standby letter of credit simply guarantees payment if a buyer fails to make the promised payment. In this case, the bank or financial institution agrees to make it instead on their behalf.
- Confirmed or unconfirmed. For this type of letter, it’s not only the issuing bank or financial institution that guarantees the payment. Instead, the seller’s institution in their home country also guarantees it in case both the buyer and their institution fail to pay. A letter of credit without this feature is considered unconfirmed.
- Revolving. Finally, a revolving letter of credit, similar to a line of credit, can be used again and again during a specified time period. It provides a blanket guarantee for payments during that time period. This type of letter may be used when two businesses want to establish a long-term relationship and don’t want the hassle of getting a new letter for each one.
Fees and rates
When an individual or business takes out a line of credit, they may be subject to a fee, either once when they open the credit line or annually. They’ll also have to pay interest on the portion of the credit line they use, similarly to how you would for a credit card.
In the case of a letter of credit, there is no interest because the business isn’t actually borrowing money from the issuing financial institution. Instead, the institution will charge a fee to the business for the letter.
A line of credit involves only two parties: the individual or business opening the credit line and the financial institution they open it with. A letter of credit, on the other hand, involves four parties: the buyer, the seller, the buyer’s bank or institution, and the seller’s institution.
What’s the difference between a letter of credit and a loan?
In the case of a loan, a financial institution lends money to an individual or business. But in the case of a letter of credit, they simply guarantee a payment on behalf of the business.
What are the four types of letters of credit?
Four common types of letters of credit are commercial letters of credit, standby letters of credit, confirmed (or unconfirmed) letters of credit, and revolving letters of credit.
Is a letter of credit a debt?
A letter of credit isn’t debt, but it does share some characteristics. For example, as in the case of secured debt, a business may be required to pledge collateral to the bank.
- A line of credit is a type of revolving debt that allows individuals and businesses to borrow on a recurring basis up to their credit limit.
- A letter of credit is a document provided by a bank that guarantees payment from a business.
- Lines of credit can be used by both individuals and businesses for large purchases or ongoing expenses. However, letters of credit are available only to businesses for purchases.
- Other key differences between lines of credit and letters of credit are the number of parties involved and the types of fees and interest charged.
View Article Sources
- What’s a Credit Inquiry? – Consumer Financial Protection Bureau
- Available Credit: How Important Is My Credit Score? – FICO
- Will Closing Credit Cards I Already Have Increase My Credit Score? – Consumer Financial Protection Bureau
- Credit 101: The Basics of Credit – SuperMoney
- What Are The Most Popular Types of Credit? – SuperMoney
- Home Equity Loan vs. Line of Credit: Which Should You Choose? – SuperMoney
- Personal Loan Vs. Line Of Credit: Which Is Better? – SuperMoney
- Personal Loans vs Credit Cards: Things You Should Know – SuperMoney