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Letter of credit vs bank guarantee: What is the difference?

Summary: A bank guarantee and letter of credit are different terms and should be used in different situations. Here is a lowdown of what the difference between bank guarantee and letter of credit is.

30 Apr 2022 by Team FinFIRST

Businesses can use a letter of credit or bank guarantee to safeguard their business relations and ensure smooth business functioning

A bank guarantee or a letter of credit is a financial guarantee for a borrower. Both demonstrate to a third party that their invoices will be paid even if the borrower cannot conjure up the funds. In this way, the bank guarantee or a letter of credit helps mitigate risk by offering financial support for the borrowing party, allowing the transaction to continue.

However, a bank guarantee and letter of credit are different terms and should be used in different situations. Here is a lowdown of what they mean.

What is a letter of credit?

A letter of credit is also sometimes called a documentary credit. It is a promissory note provided by a financial institution, such as a bank or Non-Banking Financial Company (NBFC). It assures sellers that their payment will be paid on time and in full. When a financial institution issues a letter of credit, it acts as a guarantor for the buyer.

If the buyer cannot make the payment to the seller, the financial institution makes the payment. However, specific conditions must be met for banks to cover the costs for buyers.


What is a bank guarantee?

A bank guarantee offers more value than a letter of credit. Like a letter of credit, a bank guarantee assures banks will pay money to a designated beneficiary if the opposing party cannot fulfil the contract's requirements.

A buyer or seller might use the guarantee to protect themselves from loss or damage generated by the other party's inability to comply with a contract. In a contractual arrangement, bank guarantees protect both parties from credit risk.

A letter of credit carries a higher risk for the bank but a lower risk for the merchant. A bank guarantee, meanwhile, is riskier for the merchant.

Difference between bank guarantee and letter of credit

The differences between a letter of credit vs a bank guarantee letter include:

1. Definition

A bank guarantee is a commitment made by a finance company that if a debtor fails to repay a loan, the bank will pay the amount. Meanwhile, letters of credit are essential in international trade, as it allows two parties to transact without worrying.

2. Area of use

Bank guarantees are commonly utilised in real estate agreements and construction projects, while letters of credit work better in international trade.

3. Risk

Letters of credit and bank guarantees reduce risk in a commercial agreement. The counterparties are more prone to consent to a transaction if they have a letter of credit or a bank guarantee. However, both instruments have certain risks.

4. Who uses them?

Bank guarantees are commonly used by contractors bidding on large projects. By offering a bank guarantee, the contractor establishes its financial trustworthiness. The guarantee ensures that the company behind the project is financially secure. As for letters of credit, they are used by firms that import and export items regularly.

5. Number of parties involved

A letter of credit involves five or more parties, such as the buyer, seller, providing bank, consulting bank, negotiating bank, and validating bank. A bank guarantee involves only three parties: buyers, sellers, and lenders.

6. Default

The bank makes the payment on a letter of credit when it becomes due. A bank guarantee becomes effective when the buyer cannot pay the seller.

Banks verify applicants' business details and financial statements before offering a letter of credit or bank guarantee. Once the details are closely considered, the financial institution sanctions the guarantee. However, institutions commit to being liable up to but not exceeding the payable amount. It establishes a risk threshold and safeguards their interests.



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