Letter of Credit vs. Bank Guarantee: Understanding the differences

3 March, 2025

Synopsis:

• A Letter of Credit (LC) ensures the seller receives the payment upon fulfilling contractual obligations. 
• A Bank Guarantee (BG) acts as a financial safety net for sellers in case a buyer defaults. 
• LCs are used to secure payments in international trade, while BGs are used in real estate transactions and government contracts. 
  
  

Introduction: 

International trade often involves transactions between unfamiliar buyers and sellers. That is why businesses rely on financial instruments such as Letters of Credit and Bank Guarantees. While both instruments facilitate smooth business transactions and ensure financial safety, they work differently. 

While a Letter of Credit facilitates seamless trade payments to sellers, a Bank Guarantee ensures compensation in the case of default. Understanding the difference between a Letter of Credit and a Bank Guarantee helps businesses choose the right financial tool. 

This article conducts the Bank Guarantee vs. Letter of Credit comparison, highlighting their differences, types, and usage for businesses. Keep reading. 

What is a Letter of Credit (LC)? 

A Letter of Credit is a guarantee issued by a bank on behalf of a buyer. It ensures that the seller receives payment timely upon meeting specified terms and conditions. The bank commits to paying the seller once the required documents, such as invoices and shipping documents, are verified. 

Letters of Credit are commonly used in international trade to reduce the risk of buyers not making payments after goods delivery. To obtain an LC, the buyer must approach their bank and provide the necessary details, including the transaction amount, beneficiary, and payment terms. 

Also Read: 8 types of letter of credit for business owners & traders 

What is a Bank Guarantee (BG)? 

A Bank Guarantee, on the other hand, is financial assurance provided by a bank that guarantees payment to a beneficiary if the applicant fails to meet contractual obligations. 

Unlike an LC, which ensures timely payment upon fulfilling specific terms and conditions, a BG serves as a safety net, covering financial losses due to non-payment of invoices. In such cases, the issuing bank becomes liable to make the whole payment to the seller or exporter. 

Also Read: What happens when a Bank Guarantee expires? 

Letter of Credit vs. Bank Guarantee: Key differences 

Below are the points of difference between a BG and LC: 

• Meaning 

An LC is a financial document issued by the bank that guarantees payment to the seller upon fulfilling specified conditions. A BG, on the other hand, is an assurance by the bank to cover financial losses a seller may incur if a buyer defaults. 

• Risk coverage 

An LC does not involve any risk. It simply guarantees payment to the seller upon fulfilling specified conditions and providing the required documents. Whereas, in the case of a BG, the issuing bank takes on the risk if the buyer fails to pay. 

• Usage 

Exporters and importers use LCs to secure payments in international trade, while BGs are used in real estate transactions and government contracts. 

• Payment 

In the case of an LC, the bank makes the payment when the seller meets contractual obligations. In a BG, the bank makes the payment only when the buyer defaults. 

Types of Bank Guarantee in India 

The following are the common types of Bank Guarantees in India: 

• Shipping guarantees: Ensures protection when buyers receive goods before shipping documents. 

• Performance guarantees: Protects the buyer or seller if the other party fails to fulfil contractual obligations. 

• Loan guarantees: Protects lending institutions if a borrower fails to repay their loan. 

• Advance payment guarantees: Provides protection against advance payments made by the buyers. 

• Deferred payment guarantee: Protects the seller when a buyer does not make immediate payment.  

Types of Letters of Credit 

The types of Letters of Credit include: 

• Revocable LC: Can be cancelled or modified without providing any prior notice or obtaining the seller’s consent. 

• Irrevocable LC: This cannot be modified or cancelled without the consent of all three parties involved, i.e., the buyer, the seller, and the issuing bank. 

• Confirmed LC: Includes a guarantee from a second bank for added security. 

• Sight LC: Payment is made immediately upon presentation of required documents. 

• Revolving LC: A single LC that can be used for multiple transactions. 
  
  

When to use a Letter or Credit or Bank Guarantee? 

Choosing between a Letter of Credit and Bank Guarantee depends on the nature of the transaction. Businesses should use LC when they need to provide assurance for payment in trade deals. On the other hand, a BG is ideal when a financial guarantee is needed for project completion or contract obligations. Understanding how does a Bank Guarantee differs from a Letter of Credit ensures the usage of the right financial tool. 

Conclusion 

Both LCs and BGs are vital financial tools that reduce risks in business transactions. While the former guarantees payment upon compliance with conditions, the latter acts as a safety net in the case of a default. Comparing a Letter of Credit vs. Bank Guarantee allows businesses to make informed decisions and select an appropriate financial instrument. 

​​​​​​​HDFC Bank offers a range of financial solutions for small and medium enterprises (SMEs), including Letters of Credit Services and Bank Guarantees. You can avail of these services to ensure smooth and hassle-free business operations. 

Disclaimer: *Terms and conditions apply. The information provided in this article is generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances.