For many new and already established companies, credit can be one of the main things that keep the business afloat. Unfortunately, not everyone has access to the needed amount of credit to keep their business running during a startup period or when there are other problems that make times especially difficult. In such cases, these businesses may need to acquire a letter of credit. However, in some cases, the bank will not issue one, and they must go to a private party or a donor who can secure the letter of credit with their own guarantee. This is generally known as a standby letter of credit. For many, investing in standby letters of credit is an excellent way to help a new or problematic company.

A written obligation issued by a bank which states that the bank will make payments to the beneficiary of the letter of credit if their customer, the applicant for the letter of credit does not reimburse the beneficiary the money owed by the applicant, is called a standby letter of credit. Essentially, the standby letter of credit is a form of alternative payment insurance designed to ensure that the seller in a contract receives the money owed by the buyer. It will be paid to the beneficiary, according to the stated terms in the standby letter of credit, upon request, and the issuing bank has to make the payment, even if there is any disparity between the applicant and the beneficiary.

How to secure a standby letter of credit

Securing a standby letter of credit involves a process which is actually similar to that used to apply for a loan. That the applicant submits an application at a bank, establishes credit solvency, presents cash collateral and pays a fee. The standby letter of credit function as a means of determining an applicant’s creditworthiness and the ability to make the necessary payment to fulfil his contractual obligation with the beneficiary of the standby letter of credit. If the bank issuing the standby letter of credit ends up having to pay the beneficiary, it expects the applicant to reimburse the money.

Types of Standby Letter of Credit

Most of the time, a company requests a standby letter of credit to obtain a contract. There are two main types of standby letter of credit:

  • The financial standby letter of credit: This guarantees the payment as specified by an agreement. For example, an oil refinery could arrange for a letter of this type to insure a seller of crude oil that can pay for a large delivery of crude oil.
  • The performance standby letter of credit: This is actually less common and guarantees that the client will complete the project described in a contract. In case the client does not complete the project, the bank reimburses the third party.

The term of validity of a letter of credit is usually approximately one year, which allows the applicant to make a standard payment to the beneficiary. However, a standby letter of credit is not difficult to get when you take the right steps.