Engaging in international trade requires choosing the right payment and risk management strategies to protect your business interests. With large sums involved in these transactions, deciding between a bank guarantee and a letter of credit is important. Both provide security in business deals, but they work in different ways. Learning how each works and using them correctly can help avoid issues like payment delays, disputes over contract terms, and financial losses, keeping transactions running smoothly.
What is a Bank Guarantee?
A bank guarantee is a promise made by a bank to cover a loss if a customer fails to meet their obligations. The bank agrees to pay a specific amount to the beneficiary if the applicant does not fulfill the terms of a contract.
Bank guarantees work as a safety net in business transactions. If a company cannot complete a project or make a payment, the bank steps in to cover the loss up to the guaranteed amount. This gives the beneficiary confidence to enter into business agreements with the applicant.
Common types of bank guarantees include:
Performance Guarantees: A promise that the contractor will finish the project as agreed in the contract.
Financial Guarantees: A commitment to pay if the borrower or buyer fails to meet their financial responsibilities.
Advance Payment Guarantees: Protection for the buyer that ensures repayment of any advance payment if the seller does not deliver.
Bid Bonds: A guarantee that a bidder will enter into the contract and provide required performance bonds if selected.
When comparing bank guarantees vs letter of credit options, bank guarantees are typically used when the focus is on ensuring performance or payment in case of default.
What is a Letter of Credit?
A letter of credit (LC) is a document issued by a bank that guarantees payment to a seller when specific conditions are met. It is commonly used in international trade to reduce the risk of non-payment or non-delivery of goods.
The basic process works like this:
- The buyer asks their bank to issue a letter of credit
- The bank issues the LC to the seller's bank
- The seller ships the goods and presents the required documents to their bank
- If the documents match the LC requirements, the seller's bank pays the seller
- The buyer's bank reimburses the seller's bank and collects from the buyer
Letters of credit come in several forms:
Commercial Letter of Credit: The most commonly used type in international trade; it guarantees payment to the seller if all terms and conditions are met.
Standby Letter of Credit: A secondary payment method that serves as a guarantee, used only if the buyer fails to fulfil the payment.
Revocable Letter of Credit: Can be altered or cancelled by the issuing bank at any time without notifying the beneficiary; rarely used due to its insecurity.
Irrevocable Letter of Credit: Cannot be changed or cancelled without the consent of all parties; provides stronger protection for both buyer and seller.
Bank Guarantee vs Letter of Credit: Key Differences
When making a choice between a bank guarantee vs. a letter of credit, learning their differences helps businesses select the right option for their need:
| Feature | Bank Guarantee | Letter of Credit |
|---|---|---|
| Primary Purpose | Protects against non-performance or default | Facilitates payment for goods or services |
| Payment Trigger | Only if the applicant defaults | When proper documents are presented |
| Nature | Acts as a backup; used only if the buyer fails to pay | Acts as the main method of payment |
| Claim Process | Beneficiary must prove default occurred | Beneficiary must present the required documents |
| Document Requirements | Usually requires basic documents like the guarantee letter or contract | Requires detailed paperwork such as an invoice, a bill of lading, a packing list, and an inspection certificate |
| Typical Use | Construction projects, service contracts | International trade, import/export |
| Risk Coverage | Covers the risk of non-performance or contract breach | Covers the risk of non-payment and delivery issues |
When considering bank guarantees vs letters of credit, note that bank guarantees come into effect if there is a default, while letters of credit are paid based on the presentation of required documents.
When to Use a Bank Guarantee?
Bank guarantees work best in these situations:
- Construction and Service Contracts: When a client needs assurance that a contractor will complete work as agreed
- Rental Agreements: Landlords may require bank guarantees instead of large security deposits
- Public Procurement: Government contracts often require performance guarantees
- Advance Payment Protection: When a buyer makes advance payments and needs assurance that those funds will be used properly
- Legal Requirements: Some industries legally require guarantees for certain activities
A bank guarantee vs letter of credit decision often depends on the type of risk involved. Bank guarantees focus on performance assurance, while letters of credit ensure payment based on document compliance.
When to Use a Letter of Credit?
Letters of credit are most useful in these situations:
- International Trade: When buyers and sellers are in different countries with different legal systems
- New Business Relationships: When parties do not have established trust
- High-Value Transactions: To reduce risk in large-dollar deals
- Countries with Economic or Political Instability: To ensure payment despite local conditions
- Complex Shipments: When specific shipping terms and document requirements need verification
Letters of credit are a better choice when payment security in trade transactions is the primary concern.
The choice between a bank guarantee vs letter of credit depends on your specific business needs. Bank guarantees provide security against non-performance and are typically used in service contracts and construction projects. Letters of credit focus on payment security and document compliance, making them ideal for international trade. Both tools reduce risk, but they work differently. Bank guarantees are triggered by default, while letters of credit are triggered by document presentation. Understanding these differences helps businesses select the right tool for their specific transaction requirements.
Frequently Asked Questions
1. When should a buyer use a bank guarantee?
A buyer should use a bank guarantee when they need to ensure that a seller or service provider will fulfill their contractual obligations. This is particularly useful for construction projects, service contracts, or situations where performance is the primary concern. The bank guarantee gives the buyer protection if the seller fails to deliver as promised.
2. When should a seller request a Letter of Credit?
A seller should request a letter of credit when they want to ensure payment after shipping goods, especially in international trade. Letters of credit are ideal when dealing with new customers, selling to countries with economic or political risks, handling high-value transactions, or when specific shipping and documentation requirements must be met.
3. Which is more expensive, a Bank Guarantee or a Letter of Credit?
In the bank guarantee vs letter of credit cost comparison, letters of credit are typically more expensive because they involve more documentation and bank processing. The cost of either instrument depends on several factors, including the amount covered, the term length, the applicant's creditworthiness, and the banks involved. Most banks charge an issuance fee plus processing fees.
4. Can a Bank Guarantee or Letter of Credit be transferred to another party?
Letters of credit can be transferable if specifically designated as such when issued. This allows the original beneficiary to transfer some or all rights to another supplier. Bank guarantees are generally not transferable unless specifically structured that way. In both cases, transferability must be established when the instrument is first issued.
5. How does Drip Capital work with BGs and LCs?
At Drip Capital, we specialise in trade finance solutions that support the use of both bank guarantees and letters of credit. Our export financing helps businesses manage cash flow while waiting for LC payments. For importers, we offer import financing to help cover the cost of securing bank guarantees or letters of credit. Through our digital platform, businesses can access these tools more easily, with minimal paperwork.
