Define  Pledge, Hypothecation  and Mortgage.  

 

(1) Pledge is used when the lender (pledgee) takes actual possession of

assets (i.e. certificates, goods ).  Such securities or goods  are movable

securities.  In this case the pledgee retains the possession of the goods

until the pledgor (i.e. borrower) repays the entire debt amount.   In case

there is default by the borrower, the pledgee has a right to sell the goods

in his possession and adjust its proceeds towards the amount due (i.e.

principal and interest amount).  Some examples of pledge are Gold

/Jewellery Loans, Advance against goods,/stock,  Advances against

National Saving Certificates etc.

 

(2) Hypothecation is used for creating charge against the security of

movable assets, but here the possession of the security remains with the

borrower itself.   Thus, in case of default by the borrower, the lender (i.e.

to whom the goods / security has been hypothecated) will have to first

take possession of the security and then sell the same.   The best example

of this type of arrangement are Car Loans.   In this case Car / Vehicle

remains with the borrower but the same is hypothecated to the bank /

financer.   In case the borrower, defaults, banks take possession of the

vehicle after giving notice and then sell the same and credit the proceeds

to the loan account.  Other examples of these hypothecation are loans

against stock and debtors.  [Sometimes, borrowers cheat the banker by

partly selling goods hypothecated to bank and not keeping the desired

amount of stock of goods.   In such cases, if bank feels that borrower is

trying to cheat, then it can convert hypothecation to pledge i.e. it takes

over possession of the goods and keeps the same under lock and key of

the bank].

 

(3) Mortgage :  is used for creating charge against immovable property

which includes land, buildings or anything that is attached to the earth or

permanently fastened to anything attached to the earth (However, it does

not include growing crops or grass as they can be easily detached from

the earth).  The best example when mortage is created is when someone

takes a Housing Loan / Home Loan.  In this case house is mortgaged in

favour of the bank / financer but remains in possession of the borrower,

which he uses for himself or even may give on rent. 

 

 Difference Between Pledge, Hypothecation and Mortgage at a Glance:

 

  PledgeHypothecation

Mortgage

Type of Security

Movable MovableImmovable

Possession of the security

Remains with lender (pledgee)

Remains with Borrower

Usually Remains with Borrower

       

Examples of Loan where used

Gold Loan, Advance against NSCs, Adv against goods (also given under hypothecation)

Car / Vehilce Loans, Adv against stock and debtors

Housing Loans

 

 

Pledge, Hypothecation and Mortgage Under Indian Law

 

Pledge : Section 172 of the Indian Contract Act defines pledge as "The

bailment of goods as a security for the payment of a debt or performance

of a promise"   The bailor in this case is called a Pawnor and the bailee is

called Pawnee

 

To create a valid pledge in the eyes of Law, the three important points

needs to be noted : (a) Delivery of Possession :  As in bailment, in pledge

too delivery of possession is required.  For exmaple, in Revenue Authority

vs Sundarsanam Pictures, AIR 1968, it was held NOT to be pledge because

the film producer borrowed a sum of money from a financier and agreed to

deliver the final prints of the film when ready.  Thus, there was no delivery

of the goods at the time of agreement;  (b) Delivery is in return of a loan

or promise to perform something.    Therefore, if your friend gives you his

Motor-cycle to go to college, it is not pledge but can be called simple

bailment;  (c) It should be in pursuance of a contract :  The delivery must

be done under a contract (oral or written).   However, it is not necessary

that delivery and loan take place at the same time.  Delivery can be made

even after the loan is received.

 

 

Hypothecation:   was not defined under Indian Law for long time and was

used more on the basis of practice.   However, now under the

Secruitisation and Reconstruction of Financial Assets and Enforcement of

Security Interest Act, hypothecation is defined as "a charge in or upon any

movable property, existing or future, created by a borrower in favour of a

secured creditor without delivery of possession of the movable property to

such creditor, as a security for financial assistance, and includes floating

charge and crystallization into fixed charge on movable property".  .

 

 

Mortgage :  is defined in Section 58 of the "Transfer of Property Act

1882".  It is the transfer of an interest in specific immovable property for

the purpose of securing payment of money advanced by way of loan.

 

 

What is an Assignment ?  

 

There is another term  (i.e. Assignment) which is sometimes confused with

above terms.  An assignment constitutes an action taken with a contract. 

Assignment occurs when the owner of a contract, known as the assignor,

gives a contract to another party, known as the assignee.   The assignee

assumes all responsibilities and benefits of the contract.  When it comes

to loans, assignment can relate to life insurance policies and mortgage

contract from one party to another.    Mortgages and other contracts

sometimes contain provisions limiting or stipulating conditions for

assignment.

What is a Dormant Account or What is an Inoperative Account ?

 

In layman's language dormant means inactive and inoperative means

which is not being operated i.e. no transactions have been undertaken

recently.   In terms of RBI guidelines  "A savings as well as current account

should be treated as inoperative / dormant if there are no transactions in

the account for over a period of two years".   Further clarifying the issue

RBI says  "for the purpose of classifying an account as ‘inoperative’ both

the type of  transactions i.e., debit as well as credit transactions induced

at the instance of customers as well as third party should be considered.

However, the service charges levied by the bank or interest credited by

the bank should not be considered".  However, when the interest on Fixed

Deposit account is credited to the Savings Bank accounts as per the

mandate of the customer,  it is treated as a customer induced

transaction.  However, it may be mentioned that some banks had certain

internal guidelines / periods before an account can be termed as dormant

and / or inoperative.   Bankers needs to check their internal circulars for

this purpose, but the above period of two years is applicable as per RBI

guidelines.  Therefore, as per RBI guidelines, there is no difference

between dormant accounts and inoperative accounts.

 

What is the Background for creation of different class of accounts under

the head of dormant or inoperative ?

 

Section 26 of the Banking Regulation Act, 1949 provides, inter alia, that

every banking company shall, within 30 days after close of each calendar

year submit a return in the prescribed form and manner to the Reserve

Bank of India as at the end of each calendar year (i.e., 31st December) of

all accounts in India which have not been operated upon for 10 years.  

Such deposits are considered as unclaimed deposits.   Thus, banks were

complying with these guidelines.  Slowly, the amount of unclaimed

deposits has increased to a level which came to severe criticism in the

media and some other reports.

 

To check this trend, RBI has initiated a move and wanted banks to play a

pro-active role so that unclaimed deposits can be nipped in the bud

itself.   Thus, it has issued certain guidelines to banks as to how to

monitor such dormant and inopertive accounts.    

 

What are the Rules for banks for monitoring of Dormant / Inoperative

Accounts ? Is Bank Required to inform customer about his account

becoming dormant / inoperative?

 

In terms of RBI guidelines, banks are required to make an annual review of

accounts in which there are no operations (i.e., no credit or debit other

than crediting of periodic interest or debiting of service charges) for more

than one year.   In case there have no "transactions", the bank is required

to inform the account holder to activate the account by putting through

any single debit or credit transaction which can also be put through a

third party.  If the account is still not activated and no reply is received,

the bank will classify the account as dormant at the end of two years from

the date of last transaction.   RBI has also specified the procedure to be

followed in case the letter sent is returned back.

 

However, where the account holder replies and gives the reasons for not

operating the account, bank will continue classifying the same as an

opertive account for one more year within which period the account holder

can operate the account.  However, if the account holder still does not

operate the same during the extended period, the account will be

classified as inoperative at the end of the extended period.

 

Interest on savings bank accounts should be credited on regular basis

whether the account is operative or not.

 

Banks are also advised to ensure that the amounts lying in inoperative

accounts ledger are properly audited by the internal auditors / statutory

auditors of the bank.

 

What is the purpose behind classifying the account as dormant or

inoperative ?

 

The purpose for segregation of inoperative accounts is to reduce the risk

of frauds etc.  The classification is done merely to bring the attention of

dealing staff about the increased account in such an account.   Thus,

transactions in such accounts may be monitored at a higher level both

from the point of view of preventing fraud and making a Suspicious

Transactions Report.  However, the entire process remains un-noticable by

the customer.

Can a customer issue a cheque on a dormant account ?

Yes.  However, the bank is expected to exercise due diligence as to the

genuineness of the transaction, verification of the signature, identify etc.,

and use its discretion while making payment of such cheques.

Can Bank charge for account remaining as dormant? 

Yes, bank can charge as per the schedule of charges declared by the

bank. 

Can bank charge for reactivating the same i.e. making the account again

an active account?

However, banks can not charge any fee /charges for converting a

dormant / inoperative account as operative.

What are the guidelines for unclaimed accounts ?

We have already explained about unclaimed deposits.   Banks are now

supposed to play a more pro-active role in finding the whereabouts of the

accountholders of unclaimed deposits/ inoperative accounts.   RBI has

advised banks that they should display the list of unclaimed

deposits/inoperative accounts which are inactive / inoperative for ten

years or more   on their respective websites. The list so displayed on the

websites must contain only the names of the account holder (s) and

his/her address in respect of unclaimed deposits/inoperative accounts. In

case such accounts are not in the name of individuals, the names of

individuals authorized to operate the accounts should also be indicated.

However, the account number, its type and the name of the branch shall

not be disclosed on the bank’s website. The list so published by the banks

should also provide a“Find” option to enable the public to search the list

of accounts by name of the account holder.

Banks should also give on the same website, the information on the

process of claiming the unclaimed deposit/activating the inoperative

account and the necessary forms and documents for claiming the same.

Banks are required to have adequate operational safeguards to ensure

that the claimants are genuine.

Many business organization needs funding for fulfilling their monetary requirement.

The funding can either be short term or long term. Nowadays people choose a short

term loan like cash credit and overdraft. “Cash Credit” is a type of facility

provided by the bank or financial institution in which, a company can withdraw an

amount more than what he holds in his credit against the security of

stock. “Overdraft” is another facility, in which the bank permits the customer to

debit his current account below zero but only up to a specified limit. After a

complete research, a compilation of difference between cash credit and overdraft is

made considering various criterion.

 

Content: Cash Credit and Overdraft

1. Comparison Chart

2. Definition

3. Key Differences

4. Similarities

5. Conclusion

Comparison Chart

BASIS OF

COMPARISO

N

CASH CREDIT OVERDRAFT

Meaning Cash credit is a type of short

term loan provided to

companies to fulfill their

working capital requirement.

Overdraft is a facility given by the

bank to companies, to withdraw

money "more" than the balance

available in their respective

accounts.

Security Pledge or hypothecation of

inventory.

Assets like financial instrument

and property.

Account Cash Credit Account Current Account

Definition of Cash Credit

Cash Credit is a type of short term loan facility in which the withdrawal of money by

the company is not restricted to the amount the borrower holds in his cash credit

account but up to a predefined limit. The cash credit account is functions like a

current account with cheque book facility. The facility is provided against pledge or

hypothecation of stock i.e. raw materials, work in progress, finished goods, etc. or

on the guarantee of book debts (debtors) or other collateral security as per banking

company norms. The purpose of taking cash credit is to fulfill working capital

requirement of the firm. The  cash credit limit is supposed to be equal to the

working capital requirement of the company less the margin funded by the

company itself.

The drawing limit is specified by the bank or financial institution as well as it can

vary from bank to bank and borrower to borrower. Interest is charged by the bank

on the amount utilized not on the limit sanctioned. The bank has the right to

demand money lent at any time.

 

Definition of Overdraft

Overdraft means the act of overdrawing money from the bank account. Bank

Overdraft is a facility provided by the bank to its customers withdraw money more

than the amount he holds in his account. The overdraft limit sanctioned is

predefined by the bank depending upon the securities pledged or repayment

capacity of the Account holder. The drawing limit is specified by the bank or

financial institution may vary from bank to bank and borrower to borrower. Interest

is charged on the amount utilized not on the limit sanctioned. Amount withdrawn

above the specified limit will be subject to additional charges.

The overdraft are repayable on demand i.e. the bank has the right to call the money

lent to the customer at short notice. Cheque book is provided to the account holder

to operate these account.

When the overdraft facility is provided without any security in order to meet urgent

financial needs, it is known as Clean Overdraft. However, when it is provided

against the security of assets like land & building, shares, debentures, etc. it is

known as Secured Overdraft.

Key Differences Between Cash Credit and Overdraft

1. The withdrawing facility provided by the bank in which the person can

withdraw amount more than what he holds in his credit, against the

hypothecation of stock or any other collateral security is known as cash

credit. Overdraft is another type of withdrawing facility in which the bank

allows the customer to withdraw amount more than more than what he holds

in his credit, but only upto a certain extent is known as Overdraft.

2. The Cash Credit is divided into two categories, i.e. Key Cash Credit and Open

Cash Credit. The Overdraft is divided into two categories, i.e. secured 

overdraft and clean overdraft.

3. For availing cash credit facility the borrower must have a cash credit account

with the bank or financial institution. Conversely, Overdraft facility can be

availed by the borrower, if he has a current account with the bank.

4. Cash credit facility is given against the pledge or hypothecation of inventory

or other current assets or collateral security. Overdraft facility is

given against the security of fixed assets (if securitised).

Similarities

Payable on demand

Money can be withdrawn more, than the amount actually available in the

account.

Security

Limit

Line of credit

Conclusion

For fulfilling the working capital requirement of the company at the time of ‘need’,

the banks provides many facilities. These facilities include cash credit, overdraft, bill

discounting and working capital loan, etc. Cash credit and Overdraft are the popular

ones, they are very similar in many aspects. The difference between cash credit and

overdraft is quite subtle. But, overdraft is one of the oldest concept as compared to

the cash credit.

Difference between Overdraft and Cash Credit

Overdraft and cash credit are widely used external sources of finance for availing short term borrowing at some cost. Both cash credit and overdraft are used by businesses to manage short term working capital requirements. However, they differ on various aspects which include nature of account, charges and fees, amount, purpose, type of security, use of funds, interest rate etc. 

Both these facilities are repayable on demand and therefore classified as sources of finance payable on demand or loans payable on demand. However, these facilities are rarely re-called in real-life scenario except in very rare circumstance like customer’s business and financial position is going from bad to worse phase as time passes by or in case when the value of the security is found extremely low during period re-valuation of the security or during renewal of the facility.

Although both these facilities are very similar in nature, one needs to understand cash credit vs. overdraft difference in order to understand them better.

Cash Credit Facility Overdraft Facility

Account requirement

One needs to usually open a separate cash credit account with a bank to avail cash credit facility.

Overdraft can be availed on the existing current account. It is like a facility of “excess withdrawal” given in current account and at times even in savings account.

Security Requirement

Company inventory and receivables are usually taken as security for allowing cash credit facility.

Overdraft facility does not necessarily require current assets as security. An overdraft facility may be extended by taking shares, other investments like FDs, insurance policies as security. At times even based on the credibility of the person, overdraft limit may be approved.

Limits Sanctioning RationaleLimit is usually a percentage of the stocks or receivables.

Limit is usually allotted taking into consideration the assets collateralised and also on the basis of financial statements of the company.

End Use

This is generally given specifically for the purpose of the business operation (as working capital).

Overdraft Facility can be used for any purpose and not necessarily for business.

Length of Credit Period

Cash Credit is usually for a short period. That means, the limit is allowed for a period of 1 year and is renewed every year. In some cases, renewals or review may be stipulated half yearly as well.

Overdraft facility is allowed for a very short duration at times (Say a month or even for a week in some cases), but can be allowed for a period of up to 1 year.

Limits Availability The cash credit withdrawal limit keeps changing with the change in the amount of current assets kept as security. Withdrawal limit from the CC facility is called drawing power.

The amount or the overdraft limit that the customer gets remains constant since limits sanctioned is not based on current assets. However, if OD is against shares or insurance policy surrender value, the limit changes based on the underlying security value at

periodic intervals.

Rate of Interest

The rate of interest charged under cash credit facility is lesser than what is usually charged under the overdraft facility.

The rate of interest charged under over draft facility is higher than what is usually charged under the cash credit facility.

What is the difference between overdraft and cash credit?By Investopedia

Both "overdraft" and "cash credit" can refer to a type of secured line of credit with a lender. These terms can also refer to financial institutions that allow you to withdraw more funds than you actually have in your demand deposit accounts, although the specific functionalities of these allowances can vary. These provisions are sometimes referred to as overdraft protection, while others might be called cash credits. Be aware of the policies at your own bank or credit union, and know what costs are associated with overdrawing on your account.

Both overdraft and cash credit are really forms of borrowing. The institution allows you to withdraw funds that you do not have a demand claim to, usually in small amounts. The primary differences between these two forms of borrowing is how they are secured and whether the money is lent out of a separate account.

Cash credits are more commonly offered for businesses than individuals. They require that a security be offered up as collateral on the account in exchange for cash. This security can be a tangible asset, such as stock in hand, raw materials or some other commodity. The credit limit extended on the cash credit account is normally a percentage of the value of the security offered.

Sometimes a financial institution offers a cash reserve account but calls it a cash credit instead. Cash reserves (sometimes called cash reserve credits) are unsecured lines of credit that act like overdraft protection. They typically offer higher overdraft limits and have smaller real interest costs on borrowed funds than overdrafts, since penalty fees are not assessed for using the cash reserve account.

There are several different types of overdrafts, but the two most common are standard overdrafts on individual demand deposit accounts and secured overdraft accounts that loan cash against various financial instruments.

A standard overdraft is the act of withdrawing more funds from an account than your balance would normally permit. If you have $30 in a checking account, but you withdraw $35 to pay for an item, a bank that permits overdrafts spots you the $5 and typically charges you a fee for the service. You are generally charged a separate fee for every purchase in excess of your demand deposit balance.

Overdraft accounts, however, act more like a traditional loan. Money is lent by a financial institution as with a cash credit account, but a wider range of collateral can be used to secure the credit. For example, you might be allowed to use mutual fund shares, LIC policies or even debentures. There are even clean overdraft accounts, in

which no specific collateral is offered; instead, clean overdrafts are granted against the worth of the individual. This is usually only possible when the borrower has a lot of funds parked at the financial institution and enjoys a long-standing relationship with the bank.

Advantages and Disadvantages of Bank Overdraft

A bank overdraft is a temporary facility extended by a bank to corporates and other clients to withdraw funds from their account in excess of the balance. This facility is provided by the bank for a fee and interest is charged on the excess amount that is withdrawn for the length of the time. It is important to know the advantages and disadvantages of the bank overdraft facility in order to use it effectively.

An overdraft facility allows the facility holder to withdraw money from the account despite having no balance. There is usually a limit on the amount that can be overdrawn from the account. The overdraft limit is usually set by the banks basis the amount of working capital and credit worthiness of the facility taker.

Advantages of Bank Overdraft:

o Handles Timing Mismatch of Flow of Funds: A bank overdraft is usually helpful for a business where it has cash flows moving in an out many times during a month. In other words, if sales proceeds and purchases result in flow of money in and out many times during a week / month; an overdraft facility allows managing cash flow gaps that might arise due to timing mismatch.o Helps in Keeping Good Track Record: It helps to maintain a good

payment history as any payment made via cheque does not bounce due to insufficient funds, which may have been made against some receivable, which may come a couple of days later.

o Timely Payments: It also aids in ensuring that timely payments are made and no late payments penalties are faced, as payments would be made even if there is no balance in the account.

o Less Paperwork: Overdraft facility is usually easy to avail compared to long term loans which may require more paperwork.

o Flexibility: Overdraft facility is flexible in the nature that one may take it whenever required for whatever amount (up to the limit allotted) and for even as less as one or two days.

o Benefit in Interest Cost: Since the interest is calculated only on the amount of funds utilized, there are great savings in the interest cost when compared to a normal loan taken on fixed interest rate. In other loans, you have to pay interest even if you are not using the money. The meter of interest starts with the payments you make but it stops instantly when there are receipts.

Disadvantages of Bank Overdraft:

o Higher Interest Rates: Overdraft facility comes with a cost. The cost is usually higher than the other sources of borrowing. Also if one goes above or exceeds the overdraft limit, the charges thereby are much higher.

o Risk of Reduction in Limit: Overdraft facility is a temporary loan and undergoes regular revisit by the bank. Hence, it runs a risk of decrease in the limit or withdrawal of the limit. The withdrawal of limit may happen usually when company financials may represent poor performance; hence the facility may be withdrawn largely when the company may require it the most.

o Risk of Seizing: Bank overdraft facility may at times be secured against inventory or other collateral like shares, life insurance policies etc. Company may run risk of those assets being seized, if it fails to meet payments.

o Debtor’s Collection becomes Lethargic: At times, availability of overdraft facility may make the company less strict on the collection of debtors’ payment. In other words, a company may not be too much on their feet to collect payments from debtors, as immediate payment outflows can be managed by overdraft facility.

Conclusion:

Overdraft is a temporary facility obtained by the companies to meet their ultra-short term cash shortage / requirement. One needs to bear in mind that such facility comes with high cost and should be used as a stop gap management of funds or as an emergency activity rather than a routine funding activity. Higher dependence on overdraft for working capital management indicates poor working capital management and a liquidity constraint faced by the company.  Only temporary working capital should be financed by bank overdraft. The permanent working capital should be financed by long term loans having lower interest rates.

Current Account Vs Saving Account

Whenever we go for opening an account in a bank, one thing comes to our mind –

which type of account is best suited for us – a saving account, current account,

recurring deposit account or a fixed deposit account. People normally go for either

saving bank account or current account, but they are still confused between the

two. Here, a full fledged research on it is conducted, which will help you to

understand the difference between them.

 

1. Comparison Chart

2. Definition

3. Key Differences

4. Similarities

5. Conclusion

Comparison Chart

BASIS OF

DIFFERENCESAVING ACCOUNT CURRENT ACCOUNT

Meaning A bank deposit account

that encourages savings of

a person.

A bank deposit account that supports

regular money transactions related

to a business.

Suitable for Individual Businessman or company

Interest Yes No

Withdrawals Limited Unlimited

Issue of

Passbook

Yes No

Definition of Saving Account

Savings Account is the most common type of deposit account. An account held with

a commercial bank, for encouraging savings and investments is known as a Saving

Bank Account. Savings account provides an array of facilities like ATM cum Debit

Card facility with different variants, calculation of interest on a daily basis, internet

banking, mobile banking, online money transfer etc.

The account can be opened by any Individual, Agencies or institutions (if they are

registered under the Societies Registration Act, 1860). A Pvt. Ltd and a Ltd.

company is not allowed to open a savings account.

 

Definition of Current Account

A deposit account maintained with any commercial bank, for supporting frequent

money transactions is known as Current Account. A plethora of facilities are

provided to you, when you opt for a current account like payment on standing

instructions, transfers, overdraft facility, direct debits, no limit on the number of

withdrawals/deposits, Internet Banking, etc.

This type of account fulfills the very need of an organization that requires frequent

money transfers in its day-to-day activity.

This type of account could be opened by an Individual, Hindu Undivided Family

(HUF), Firm, Company, etc. Account maintenance charges are applicable as per the

bank rules. The current account is also known as checking account or

atransactional account.

Key Differences Between Savings Account and Current Account

1. An account that stimulates savings and investments is known as Saving

account. An account that advocates highly liquid transactions is known as a

current account.

2. Saving Account is ideal for salaried people because of regular monthly

savings. Conversely, Current Account is ideal for businessmen because of day

to day money transactions.

3. There is a restriction on the number of monthly transactions, in case of a

savings account. There is no such cap for a Current Account.

4. The major difference between them is current account is non-interest bearing

whereas savings account offers interest on daily basis.

Similarities

Type of Demand Deposit

Internet Banking Facility

Multi city Cheque Facility

Nomination facility

Conclusion

We have discussed in detail about both the entities and it is quite clear that the two

are important in place. If we talk about the major difference between them, it is the

number of transactions – withdrawal or deposit .

Letters of creditWhat is a letter of credit?A letter of credit - sometime known as 'documentary credit' - is basically a guarantee from a bank that a particular seller will receive a payment due from a particular buyer. The bank guarantees that the seller will receive a specified amount of money within a specified time. In return for guaranteeing the payment, the bank will require that strict terms are met. It will want to receive certain documents - for example shipping confirmation - as proof.

Why use a letter of credit?Letters of credit are most commonly used when a buyer in one country purchases goods from a seller in another country. The seller may ask the buyer to provide a letter of credit to guarantee payment for the goods.

The main advantage of using a letter of credit is that it can give security to both the seller and the buyer.

Advantages for sellersBy asking for an appropriate letter of credit a seller is reassured that they will receive their money in full and on time. A letter of credit is one of the most secure methods of payment for exporters as long as they meet all the terms and conditions. The risk of non-payment is transferred from the seller to the bank (or banks).

Advantages for buyersWhen a buyer uses a letter of credit they get a guarantee that the seller will honour their side of the deal and provide documentary proof of this.

Other things to considerIt's important to be aware of the additional costs involved in using a letter of credit. Banks make charges for providing them, so it's sensible to weigh up the costs against the security benefits.

If you're an exporter you should be aware that you'll only receive payment if you keep to the strict terms of the letter of credit. You'll need to give documentary proof that you have supplied exactly what you contracted to supply. Using a letter of credit can sometimes cause delays and other administrative problems.

A Letter of Credit is a payment term mostly used for long-distance and international commercial transactions.

Letters of credit are indispensable for international transactions since they ensure that payment will be received. Using documentary letters of credit allows the seller to significantly reduce the risk of non-payment for delivered goods, by replacing the risk of the buyer with that of the banks. Letters of credit have become a crucial aspect of international trade , due to differing laws in each country and the difficulty of knowing each party personally.

After trade between countries made it impossible to do business by traditional payment methods, Letters of credit make it possible to do business worldwide.

Originally, Letter of Credit was literally a letter written by the buyer's bank to the seller's bank promising that they guarantee to pay the seller in case of the buyer's default.

In modern business world, a letter of credit is basically an undertaking by a bank to make a payment to a named Beneficiary within a specified time, against the presentation of documents which is strictly in compliance with the terms of the letter of credit.That is to say, banks issue letters of credit as a way to ensure sellers that they will get paid as long as they do what they've agreed to do. Hence, in essence, letter of credit is a promise to pay.This mechanism has its own jargon:The Buyer is the Applicant or the Account Party and the Seller or the Ultimate Recipient of Funds is the Beneficiary.

The Bank that issues the LC is referred to as the Issuing Bank which is generally in the country of the Buyer.The Bank that Advises the LC to the Seller is called the Advising Bank which is generally in the country of the Seller

Abbreviations for 'letter of credit' include L/C, LC, and LOC .In the very beginning, one must note that Letters of credit deal in documents, not goods, thus the Bank scrutinizes the 'documents' and not the 'goods' for making payment which explains why the technical term for Letter of credit is 'Documentary Credit'.

In this context, the process works both in favour of both the buyer and the seller. The instrument is designed to reduce the risk taken by each party. The Seller gets assured that if documents are presented on time and in the way that they have been requested on the LC the payment will be made and Buyer on the other hand is assured that the bank will thoroughly examine these presented documents and make sure that they meet the terms and conditions stipulated in the LC.

Letter of credit advantages for the seller

The seller has the obligation of buyer's bank's to pay for the shipped goods; Reducing the production risk, if the buyer cancels or changes his order The opportunity to get financing in the period between the shipment of the

goods and receipt of payment (especially, in case of deferred payment). The seller is able to calculate the payment date for the goods. The buyer will not be able to refuse to pay due to a complaint about the

goods

Letter of credit advantages for the buyer

The bank will pay the seller for the goods, on condition that the latter presents to the bank the determined documents in line with the terms of the letter of credit;

The buyer can control the time period for shipping of the goods; By a letter of credit, the buyer demonstrates his solvency; In the case of issuing a letter of credit providing for delayed payment, the

seller grants a credit to the buyer. Providing a letter of credit allows the buyer to avoid or reduce pre-payment.