Letters of Credit vs. Bank Guarantees: What’s the Difference?

Letters of credit and bank guarantees both have an important role to play when it comes to supporting international trade. Although they can both be used to mitigate risk and build trust between businesses, they are typically used in different ways.

To give you a better idea of which one is best suited to your company, we explain how they work, the various types you can use and the potential benefits they can offer.

What is a letter of credit?

A letter of credit is a secure payment method issued by a foreign buyer’s bank to guarantee that payment is made to the seller. This helps to remove the risk to the seller that the buyer will not make the required payment.

It offers protection for both buyers and sellers, as the importer is offered reasonable payment terms and the exporter is guaranteed payment. This falls under the umbrella of commercial bank services​, helping to facilitate global trade and business growth.

What are the different types of letters of credit?

There are several types of letters of credit that can be used depending on the intended purpose:

• Revocable: This allows the buyer to modify or cancel the letter without notice.
• Irrevocable: Once issued, changes cannot be made without consent from all parties.
• Confirmed: Even if the buyer’s bank fails, this letter ensures that made will still be made.
• Unconfirmed: An unconfirmed letter of credit only requires commitment from the issuing bank.
• Transferable: Part or all the credit can be transferred to another party.
• Standby: Works in a similar way to a bank guarantee, allowing the seller to draw funds even if the buyer does not meet their obligations.

Businesses may prefer to use a letter of credit to ensure payment is made once they have fulfilled the contract terms, especially with buyers that require strict compliance.

What are the benefits of a letter of credit?

Using a letter of credit can offer the following benefits for sellers:

• Payment is guaranteed by the issuing bank provided the seller meets the full terms detailed in the letter.
• Buyer default is less of a problem, as the buyer’s bank takes on the financial risk.
• Sellers can widen their network and engage with partners in territories to expand their operations.

Letters of credit benefits for buyers:

• Providing a letter of credit can increase a buyer’s negotiating power, as they can guarantee that payment will be made.
• As long as the terms and conditions contained in the letter are fulfilled, buyers have more assurance that they will receive their goods.
• A letter of credit can also serve as a credit certificate, as the funds are only transferred once the transaction is complete and the terms fulfilled.

What is a bank guarantee?

A bank guarantee is a commitment from a bank that it will serve as a guarantor for a borrower. This means that the bank will step in to pay a specified beneficiary if the borrower is unable to uphold their obligations.

By acting as a guarantor, this provides financial cover for businesses should the worst happen. The seller will still receive the money they are owed by the other party, so they are not forced into a difficult financial situation.

What are the different types of bank guarantee?

The most common types of bank guarantee tend to be:

• Performance guarantees: This promises that the project will be finished as agreed by the contractor.
• Financial guarantees: If the buyer or borrower does not meet their financial responsibilities, this ensures that payment will be made.
• Advance payment guarantees: This ensures that any advance payments made are repaid if the seller fails to deliver.
• Bid bonds: When a bid bond is used, it guarantees that a bidder will commit to a contract and deliver the required performance bonds.

Bank guarantees tend to be the best option when payment or performance is the priority in case of default.

What are the benefits of a bank guarantee?

If a bank guarantee is more appropriate for your business, it could help to:

• Provide financial protection in the event of a contract breach, ensuring that beneficiaries are compensated.
• Offer a safety net should the applicant default or not fulfil the agreed terms, as the bank will step in to provide payment.
• Build trust and enhance creditworthiness, as it demonstrates financial reliability and stability on the buyer’s part.
• Protect working capital, ensuring businesses do not have to set aside large sums of cash, freeing up important capital for the company.
• Make it easier to secure additional credit as lenders tend to view companies backed by guarantees as low risk.

Final thoughts

Letters of credit and bank guarantees help to reduce risk in international trade, while opening the door to new markets and trading partners. A letter of credit ensures payment is made once certain conditions are fulfilled, while a bank guarantee offers assurances of payment should a buyer default. Where one may be appropriate for a particular type of  transaction, the other may be better suited to a different business arrangement, as they are not necessarily interchangeable. If you are not sure which is the right one for you, speak with your bank provider to get more insight before agreeing to any terms.