A bank guarantee and a letter of credit are similar in many ways but they’re two different things. Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn’t go as planned.
The bank guarantees a sum of money to a beneficiary. The sum is only paid by the bank if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.
A bank guarantee might be used when a buyer obtains goods from a seller then runs into cash flow difficulties and can’t pay the seller. The bank guarantee would pay an agreed-upon sum to the seller. Similarly, if the supplier was unable to provide the goods, the bank would then pay the purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety measure for the opposing party in the transaction.
Letter of Credit:
It is an obligation taken on by a bank to make payment once the certain criteria are met. Once the terms are met and confirmed the bank transfers the funds. It ensures that till the conditions are met, payment will be made.
The letter of credit Is to be used in cases such as delivery of goods and completion of services. The seller asks the buyer to obtain the letter from the bank before the transaction occurs. The buyer purchases the letter and forwards it to seller’s bank. It substitutes the bank’s credit for that of the client, ensuring correct and timely payment.