Bank Guarantee vs. Letter of Credit: What's the Difference?

It is often seen that people perceive both the Letter of credit and Bank guarantee through the lens of functionality. They have a preconceived notion that BG and Letter of credit are the tools to facilitate international trade through secure and timely payments. However, this is not an appt assessment as each of the two tools is distinct, and has several differentiating factors. Here, we bring you closer to the difference between both the mediums.

Definition

Letter of credit: A letter of credit is a financial document that is issued by the bank to ensure that the seller will receive the payment in full and on time. Provided the seller complies with his side of the agreement and he (seller) needs to present a documentation proof to certify that he has kept his part of the agreement.

Bank guarantee: A Bank Guarantee is another form of financial instrument which provides the security of the payment to the seller in case the other party defaults in payment.

Boundary, and popularity

Bank Guarantee: It is most commonly used domestically, on the other hand, the LOC is used internationally. Though Letter of Credit is used internationally, in terms of popularity, it falls behind the Bank Guarantee form of financial instrument.

Security and use

A letter of Credit shares the risk of trade activity in terms of payments and receipts equally between both the importer and exporter respectively. However, in the case of Bank Guarantee, the bank favors the importer and makes the transaction on behalf of the buyer party.

Letter of credit is used by merchants across the globe, while the use of Bank Guarantee is prevalent in the real estate arena. Here, a bank guarantee can be formed between a construction company and the cement supplier.

Fundamental difference

It is important to note there is one fundamental difference between the Bank Guarantee and Letter of credit. In the case of BG, the bank makes the payment for said amount only if the third party or the importer fails to make the payment. In LOC, a bank makes payment on behalf of the third party as a part of a natural payment process

Types of Guarantee and Letter of Credit

Bank Guarantee

There are four types of Bank Guarantee, the list of which is mentioned below.

- Performance guarantees
- Tender guarantees
- Payment Guarantee
- Advance payment Guarantee

Letter of credit

There are five types of letter of credit:

- Irrevocable Letter of Credit
- Confirmed Irrevocable Letter of Credit
- Revocable Letter of Credit
- Revolving Letter of Credit
- Unconfirmed Irrevocable Letter of Credit