The most important thing in big transactions and business nowadays is to reduce the risk. When two people or companies are involved in a big deal, they may sometimes doubt each other's financial reliability. So in such a situation, a bank guarantee and a letter of credit are very useful. Both of these are promises given by the bank that if the person making the payment is unable to pay the money, then the bank will make the payment on his behalf. This makes the transaction safe, and trust remains. Although the purpose of both is to reduce the risk, they are quite different in the way they work and use cases, so let's understand the main differences between the two.

What is a bank guarantee?

Let us tell you that a bank guarantee is a promise of trust, in which the bank says that if a party is unable to fulfill its promise, then the bank will compensate for the loss on its behalf; this is a legal responsibility for the bank.

Understand this with an example.
Suppose a construction company gets a contract to build a mall and has made an agreement with a cement supplier, then the supplier has to deliver the cement on time. In such a situation, both parties take a bank guarantee for trust. If the supplier does not send the cement on time, then the construction company informs the bank about it. Then the bank compensates for the loss, the amount that was fixed in the guarantee. So in this way, the bank guarantee provides a kind of safety, so that the other party does not suffer due to the mistake of one.

What is its use
: By the way, a bank guarantee is often used in big infrastructure projects, real estate deals, and domestic business.

What is a letter of credit?

A letter of credit, also known as documentary credit, is a promise given by a bank that it will make payment to the seller on behalf of its customer (buyer). This payment is made only when the seller sends the goods on time and submits all the necessary documents to the bank. This method is especially used to maintain trust in international trade.

Understand it with an example.

Suppose an Indian company wants to buy goods from a company abroad, but there has been no previous transaction between the two companies, so there is a lack of trust. In such a situation, the Indian company can get a Letter of Credit issued from its bank. It is a guarantee that if the foreign company sends the goods as per the agreed terms and submits the necessary documents (such as documents of loading of goods), then the bank will take responsibility for its payment. By doing this, the seller is confident that he will get the money on time, even if the buyer fails to pay.

What is its use:
By the way, it is mainly used in international trade, where the buyer and the seller do not know each other personally, and they are in different countries.

Main difference between a bank guarantee and a letter of credit:

1-Both bank guarantee and letter of credit strengthen trust in business, but the work of both is different.

2-Bank guarantee is a kind of security that if a party does not fulfill the terms of the agreement, then the bank compensates for the loss.

3- A letter of credit is a promise that if the seller fulfills all the conditions, then the bank will make the payment on behalf of the buyer.

So, in any deal, it is important to understand which option will be right for you in which situation.

Disclaimer: This content has been sourced and edited from Zee Business. While we have made modifications for clarity and presentation, the original content belongs to its respective authors and website. We do not claim ownership of the content.