The businesses whether they are small, medium or large, require working capital funds some or other day for their day to day operations.
The first and foremost thing that comes to mind when it comes to credit/ loan, is traditional business loans, personal loans. However, there are some other options available that are favourable and convenient to small or medium business owners.
In this article, we will discuss prominent credit facilities available for businesses to cater to their requirements of working capital funds. However, the most prominent credit option available for businesses is the letters of credit and lines of credit.
We will discuss what are the major differences between lines of credit vs letters of credit and their advantage and disadvantages further in this article.
Table of Contents
Line of Credit & Letter of Credit:
Let us first understand what exactly are the lines of Credit as well as Letter of Credit.
The line of credit refers to a form of business credit but differ from typical business loans in terms of tenure, the applicable rate of interest, the amount at which interest is applicable.
In other words, a line of credit is just like a normal credit card which many people utilise to fulfil their personal needs. The difference is, lines of credit are used in businesses/ organisations.
In line of Credit, a certain credit limit (say $ 1,00,000) is allotted to the businesses and they can borrow funds to that certain extent only. The rate of interest would be applicable to withdrawn funds only.
You can withdraw the money as many times as you require but up to the allocated credit limit and then repay in time. The line of Credit provides more flexibility than regular business loans.
On the other hand, a letter of credit refers to the financial documents/ instruments issued by the commercial banks or other financial institutions as a guarantee of the payment of a certain sum of money by the buyer’s banks to the seller’s bank.
In simple words, a letter of credit is a financial agreement between the buyer’s bank and seller’s banks for the payment of a specified sum of money to the seller in the stipulated time period.
The letters of Credit (L/C) are typically used in international trades where the buyers and sellers are unknown to each other and the legal procedures of the two countries are different as well. The LCs are used in high-value transactions between two parties of different countries.
Lines of Credit vs Letters of Credit:
Although the line of credit and letter of credit looks similar terms, hence most people assume them similar, but they are completely different from each other. However, one similarity is there, both are used by businesses or corporations.
However, their definitions didn’t clarify their differences yet. Hence let us understand the difference between a line of credit and a letter of credit now.
No matter, how similar these two terms are? They should never be miss understood similar. Their differences lies in their meaning.
The most prominent difference is that a line of credit is a type of loans, on the other hand, a letter of credit is a guarantee of one-time payment on account of certain trade between two parties (buyer & seller).
2) Parties Involved:
There are basically two parties involved in the case of a line of credit ie. borrower & banks or financial institutions. However, in the letter of credit, there are basically five parties involved during trade/ transactions namely Buyer, Seller, Advisory bank, Negotiating bank, confirming bank etc.
3) Fees/ Rate of Interest:
As lines of credit are some kind of loans, therefore, an interest rate is applicable to them. On the other hand, a one-time fee is applicable in case of a letter of credit (LC) payable to the banks by both buyer and seller.
Collateral may or may not be required while availing a line of credit which depends upon the creditworthiness/ CIBIL score of businessmen.
However, in the case of a letter of credit collateral whether it is actual cash, land, machinery etc is required at the time of issuing a letter of credit.
Another major difference between letter of credit and line of credit lies in their usage.
The letters of Credit are utilised more specifically during international trade to mitigate the credit risk of buyers because of different countries’ rules and regulations, distance.
Whereas, the lines of Credit are suitable for small/ medium business owners and used to cater their day to day expenses, inventory maintenance or expansion of the business.
Another significant ground of differentiation between the line of credit and letter of credit is their types. The letters of Credit (L/C) could be of different types for facilitating both buyers as well as the seller.
In other words, its terms and conditions can be modified according to the needs of both parties which results in several types of LC as follows.
- Commercial Letter of Credit
- Standby Letter of Credit
- Revocable/ Irrevocable LC
- Confirmed/ Unconfirmed LC
- Back to back LC
- Red-clause LC
- Revolving LC, etc
For more detailed explanation, follow the link below.
On the contrary, a Line of Credit is not only used for business, but also for personal or investment purposes. Some popular types of lines of Credit are:
- Personal Line of Credit
- Home-equity lines of Credit (HELOC)
- Security-backed LoC
- Business Line of Credit
- Demand LoC
Difference between Line of Credit and Letter of Credit:
Let’s have a quick revision with help of following comparison table.
|Basis of Comparison||Line of Credit||Letter of Credit|
|Meaning||LOC is a type of loan/ credit, |
used for business/ personal credit.
|L/C is a financial instrument that guarantees|
the payment from one party to another party,
usually used in international transactions.
|Parties Involved||Borrower & Lender||Buyer, Seller, Advisory Bank, |
Negotiating Banks, Confirming Bank
|Collateral||May/ May not be required||Required|
|Fees/ interest||Fixed or Variable interest rate||Fixed Fees charged by the bank|
|Usage||Generally, used in domestic businesses||Used during international trade/ transactions|
Both lines of credit and letter of credit have their own pros and cons. Whether you’re a business people or a student, this article intends not to misunderstand these terms similar.
However, both are suitable for different kind of businesses or trade or transactions.