Letter of Credit vs Bank Guarantee: Meaning, Examples, and Comparison Table
Understanding the difference between Letter of Credit and Bank Guarantee is essential for students of Commerce, especially for exams in Class 11, 12, B.Com, and those preparing for competitive tests. These are key financial instruments used worldwide to ensure secure business and trade transactions. Knowing how they differ helps in business decision-making and exam performance.
| Aspect | Letter of Credit (LC) | Bank Guarantee (BG) |
|---|---|---|
| Meaning | Payment assurance by bank to seller when buyer defaults | Bank promises compensation to the beneficiary if applicant fails |
| Who is Protected? | Seller (Exporter/Supplier) | Beneficiary (Buyer or Project Owner) |
| Payment Terms | Payment made on fulfilling contract terms | Payment happens only on default of applicant |
| Usage Area | International trade, imports/exports | Construction contracts, supply contracts, loans |
| Example | Bank pays exporter if importer fails to pay | Bank pays project owner if contractor fails |
Definition and Overview: Letter of Credit and Bank Guarantee
A Letter of Credit (LC) is a written commitment from a bank to pay the seller (exporter) a specified amount if the buyer (importer) does not pay, provided all terms are met. A Bank Guarantee (BG) is a financial promise by a bank to cover losses if the applicant defaults on the contract. Both tools give trust and security in business deals.
Key Differences Between Letter of Credit and Bank Guarantee
Though both provide security in business transactions, their role, conditions, and practical use differ. The table above lists the direct comparison most relevant for exams and business understanding. Focus on which party each protects, when the bank pays, and where they are used.
Types and Purposes of Letter of Credit and Bank Guarantee
Both LC and BG have various types. Knowing these helps in exams and business applications. Their purpose is mainly to assure payment or performance in financial or commercial contracts.
Types of Letter of Credit
- Revocable LC: Can be changed or cancelled by issuing bank anytime.
- Irrevocable LC: Cannot be changed without all parties' consent (most common).
- Confirmed LC: Another bank guarantees payment along with the issuing bank.
- Revolving LC: Can be used for multiple transactions up to a limit.
- Standby LC: Works like a guarantee if buyer defaults.
Types of Bank Guarantee
- Performance Guarantee: Compensates if work is not completed.
- Financial Guarantee: Covers non-payment of money.
- Advance Payment Guarantee: Ensures reimbursement if advance money is misused.
- Bid Bond Guarantee: Used in tender bids.
- Shipping Guarantee: For releasing goods before documents are received.
Difference Between Letter of Credit and Bank Guarantee with Example
Understanding real business cases brings clarity to the difference between LC and BG. Here are practical illustrations:
Letter of Credit Example
An Indian import company orders machines from a German exporter. The importer’s bank issues an LC to the exporter. If the Indian company fails to pay, the bank must pay the exporter on presenting the required documents. This secures the exporter against payment risk.
Bank Guarantee Example
A construction company in India takes a contract to build a government bridge. The firm’s bank provides a performance bank guarantee to the government. If the company fails to complete the project, the bank will compensate the government for its loss, up to the guarantee amount.
Practical Use Cases and Indian Context
In India, LCs are mainly used in international trade for importing goods and ensuring exporters get paid. Bank Guarantees are common in construction tenders, government projects, and supply contracts to ensure serious commitment. Both relate to financial markets and are seen as non-current liabilities in company accounts.
Summary of Letter of Credit vs. Bank Guarantee
To summarise, a Letter of Credit directly assures payment to the seller if the buyer defaults, mostly supporting international trade. A Bank Guarantee promises compensation to the beneficiary if the applicant fails to meet contract terms, often used in project and government contracts. Knowing the difference between Letter of Credit and Bank Guarantee helps in exams and real-life business applications.
FAQs on Difference Between Letter of Credit and Bank Guarantee
1. What is the major difference between a Letter of Credit (LC) and a Bank Guarantee (BG)?
The main difference lies in who is protected: an LC protects the seller, ensuring payment, while a BG protects the buyer, ensuring the seller's performance. An LC is a payment mechanism, a BG is a performance guarantee.
2. Is a Letter of Credit the same as a Bank Guarantee?
No, a Letter of Credit (LC) and a Bank Guarantee (BG) are distinct trade finance instruments. An LC assures payment to a seller, whereas a BG assures the fulfillment of a contract obligation by a party.
3. Can you explain the difference between LC and BG with an example?
In an import, an LC ensures the importer's bank pays the exporter once the goods are shipped. A BG in construction ensures the contractor completes the project; if not, the bank compensates the client. LCs focus on payment, BGs on performance.
4. What are the different types of Bank Guarantee?
Bank Guarantees come in various types, including performance guarantees (project completion), bid bonds (tendering), advance payment guarantees (initial payments), and standby letters of credit (payment on default). The specific type depends on the contract's needs.
5. When is a Letter of Credit used in business?
Letters of Credit (LCs) are commonly used in international trade to mitigate risks for both importers and exporters. They provide payment assurance to sellers and confidence to buyers in cross-border transactions, particularly in high-value deals. LCs are especially vital in reducing risks in transactions with unknown parties.
6. What is a Standby Letter of Credit vs. a Bank Guarantee?
A standby letter of credit (SLC) acts like an insurance policy; the bank pays if the buyer defaults. A Bank Guarantee (BG) is triggered only if a specific contract obligation is not met, offering a narrower scope of protection than an SLC. Both function as safety nets in commercial transactions.
7. What is the difference between letter of credit and bank guarantee in hindi?
In Hindi, a Letter of Credit (LC) is 'साख पत्र' and a Bank Guarantee (BG) is 'बैंक गारंटी'. The core difference remains the same: an LC secures payment for the seller, while a BG ensures the buyer that the seller will fulfill contractual obligations. Both are crucial financial instruments for Indian businesses.
8. What is the difference between standby letter of credit and bank guarantee?
While both standby letters of credit (SBLCs) and bank guarantees (BGs) offer payment or performance assurances, an SBLC functions more like insurance, paying if a contract condition isn’t met. A BG is triggered only by a specific contract breach. Choosing between them depends on the context and risk appetite.
9. What is bank guarantee and letter of credit?
A bank guarantee (BG) is a bank's promise to compensate a beneficiary if a customer (applicant) fails to fulfill a contractual obligation. A letter of credit (LC) is a bank's undertaking to pay a seller on behalf of a buyer once the seller fulfills the contract terms. They are both trade finance tools but serve different purposes.
10. What is the difference between letter of credit and bankers acceptance?
A Letter of Credit (LC) is a bank's guarantee of payment to a seller, issued on behalf of a buyer. A banker's acceptance is a short-term debt instrument where a bank accepts liability for payment of a time draft. While both involve banks, an LC is primarily for trade transactions, while a banker's acceptance is a financing tool.
11. Difference between letter of credit and bank guarantee with example?
A Letter of Credit (LC) assures payment to the seller, like an importer’s bank guaranteeing payment to an exporter post-shipment. A Bank Guarantee (BG) assures performance, like a bank guaranteeing a contractor will complete a project; if they fail, the bank pays the client. The difference lies in what is guaranteed: payment (LC) versus performance (BG).
