Confirmed Letter of Credit Definition – Credit & Debt
What Is a Confirmed Letter of Credit?
A confirmed letter of credit is a guarantee a borrower gets from a second bank in addition to the first letter of credit. The second letter guarantees the second bank will pay the seller if the first bank fails to do so.
The borrower may be required to get a second letter of credit if the seller decides the issuing bank of the first letter of credit has questionable creditworthiness. The second letter decreases the risk of default for the seller.
A letter is considered unconfirmed it the first letter of credit is not backed by a second guarantee.
- A confirmed letter of credit is a guarantee a borrower gets from a second bank in addition to the first letter of credit.
- The confirmed letter decreases the risk of default for the seller.
- By issuing the confirmed letter, the second bank promises to pay the seller if the first bank fails to do so.
Understanding Confirmed Letters of Credit
A second letter of credit requires the backing of more than one bank by a buyer in a domestic or international transaction. A confirmed letter of credit may be required if the seller is not satisfied with the creditworthiness of the first letter of credit. So when the buyer gets the second letter, it confirms the first one and qualifies it as a confirmed letter of credit.
When it issues the confirmed letter of credit, the second bank promises to pay the seller the amount stated if the first bank fails to do so.
The process of securing a second letter of credit is the same as the first letter of credit. The buyer will have to find a second bank to back its purchase in case of default. The buyer must go through the same process to be approved for a second letter of credit.
The same bank cannot issue the first and confirmed letters of credit.
The structuring of the funds for the second letter of credit generally takes the terms of the first letter of credit into consideration as well. In some cases, the seller may only require the second letter of credit represent a percentage of the total due because the sale already comes attached with a credit letter by the first bank.
First Letter of Credit
A letter of credit is commonly needed in business transactions that require substantial payment for goods or services. Instead of requesting an advance payment, the seller may require the buyer to obtain a letter of credit for the balance of the payment owed at the time of full delivery.
A buyer must work with a bank to secure the first letter of credit. This requires a full credit application just like that of a loan. If the bank approves the letter of credit, it documents its willingness to pay the seller the stated amount if the buyer defaults at the time of payment. The terms of the letter will typically structure the payment as a loan for the buyer.
If the buyer is unable to make the payment to the seller at the time when the funds are due, the bank will issue the payment as a loan to the buyer. Upon receiving the letter of credit, the buyer also agrees to the bank’s loan terms. If required, the terms of the loan will include a stated interest rate and payment schedule as well as other disclosures regarding repayment.
If the seller is satisfied with the first letter of credit they may accept it as an unconfirmed letter of credit. Unconfirmed letters of credit require the support of only one lending bank.