What's a Letter of Credit? Are funds held in my bank for the amount in question?
Can someone easily cash one? Is it used for business only, or is there an advantage to consumers using them as well?
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A letter of credit is commonly used by importers who want to ensure that their product is shipped before paying the exporter. The exporter has a guarantee that the payment for the goods will be received once the shipment has been made.
It is used to resolve a Game Theory type situation. For example, you are buying a car from China for ,000 USD. The exporter of the car asks for the money before he will ship the car, but if you give him the money, then he has no incentive (aside from legal pressures) to ship the car. Instead you sign a letter of credit for the transaction, which basically sends your payment to the exporters bank, but puts a hold on it until the exporter proves that he has shipped the car and proved that he has insured the shipment against damages.
In a domestic setting, Letters of Credit are often used to build public works needed to support a development.
So if you're bulldozing a few 3 story buildings to build a 50 story tower, the municipality will build appropriate water/sewer/gas/road infrastructure, and draw from the developer's letter of credit to fund it. The 'catch' to the developer is that these things usually aren't revokable -- once the city/town/etc starts work, the developer cannot cut-off the funding, even if the project is cancelled.
A letter of credit definitely isn't a consumer financing vehicle. The closest equivalent is a "line of credit" tied to an asset like a home.
Ok so this is the best information I could get! It is a guarantee from a financial institution that payment will be made for items or services once certain requirements are met. Let me know if this helps! I'll try to get more info in the meantime.
Wikipedia has a detailed article explaining this.
A standard, commercial letter of credit (LC) is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking.
So yes, they are primarily for use by businesses. If you will read the article stating the terms and conditions for payment and shipment you will realize that such model won't be of much value to and will create many hurdles for a typical consumer.
Yes, you can cash a letter of credit but only once the conditions in the letter have been met (e.g., delivery/shipment of goods/services). An array of documents need to be presented as well. Whether it is easy or not is a very subjective question.
A bank will issue a letter of credit only when it is reasonably sure that its risk is covered --either backed by a bank deposit or by conditions in the letter itself. Obviously derivatives on these letters have evolved as well.
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