Letter of Credit vs Bank Guarantee: When to Use Each in Indian Trade

Understand when a letter of credit makes sense versus a bank guarantee, the parties involved, and the typical cost in Indian trade scenarios.

Two Instruments, Two Purposes

A letter of credit, or LC, is a payment instrument where the buyers bank promises to pay the seller against compliant shipping documents, used primarily in cross-border and high-value domestic trade. A bank guarantee, or BG, is a default instrument where the bank promises to pay the beneficiary only if the principal fails to perform a contractual obligation. The LC is the primary mode of payment, the BG is a backup that ideally never gets invoked. Confusing the two leads to expensive structural errors in commercial contracts.

Parties in a Letter of Credit

An LC transaction involves the applicant who is the buyer, the issuing bank that is the buyers bank, the beneficiary who is the seller, and the advising or confirming bank in the sellers country. The seller ships goods, submits the bill of lading, invoice and other documents to its bank, which forwards them to the issuing bank for payment. The issuing bank pays once documents match the LC terms exactly, even if the underlying goods are defective. Document discrepancies are the leading cause of LC payment delays and are entirely a paperwork issue.

Types of Bank Guarantees

Bid bonds are submitted with tenders to prove the bidders seriousness, performance guarantees back the contractors execution of the contract scope, and advance payment guarantees protect the buyer who has paid an advance against non-performance. Financial guarantees secure pure payment obligations, while deferred payment guarantees back instalment-based capital goods purchases. Each type has standard wording prescribed by the issuing bank, but the beneficiary can usually negotiate specific protective clauses. A BG that is unconditional and on-demand is the strongest, requiring no proof of default for the beneficiary to invoke.

Cost and Margin Requirements

Indian banks typically charge 0.5% to 2% per annum on the LC amount, split between opening commission and usance interest if it is a deferred payment LC. Bank guarantee commission is usually 0.5% to 1.5% per annum, with the rate depending on the customers credit rating and the BG type. Both instruments require cash margin, typically 10% to 100% of the value, plus collateral coverage for the balance, which ties up working capital. For exports, the LC also generates packing credit eligibility, which makes the cost worthwhile despite the margin block.

When to Push for One Over the Other

In exports to a new buyer in a country with weaker legal recourse, an irrevocable confirmed LC from a top-tier bank is non-negotiable. For domestic capital goods sales with milestone deliveries, an advance payment BG from the customer combined with a performance BG from you gives both sides comfort. Pure service contracts rarely need either, since there are no shippable goods to document. BillBabu helps you track LC and BG expiry dates against the underlying contracts and customers, so you never miss a renewal that could lock up your shipment.

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