What Is a Transferable Letter of Credit?

A transferable letter of credit is a letter of credit that allows the first beneficiary to transfer some or all of the credit to another party, creating a secondary beneficiary. The party that initially accepts the transferable letter of credit from the bank is referred to as the first, or primary, beneficiary, while the party that applied for the letter of credit is the applicant. A transferable letter of credit is often used in business deals to ensure payment to a supplier or manufacturer and is an alternative to making an advance payment.

How Transferable Letters of Credit Work

A letter of credit is a document provided by a bank, guaranteeing that a seller will receive the money a buyer has promised to pay it for goods or services in a particular transaction. If the buyer fails to do so, the bank can become responsible for paying.

For example, sellers of manufactured goods often require a letter of credit guaranteeing that they will receive the money they are due—on time and for the full, correct amount—before proceeding to fill a customer's order. The buyer applies to a bank to obtain the letter of credit and pays a fee to compensate the bank for the risk it is taking.

Letters of credit are often used in transactions between importers and exporters. As the U.S. Department of Commerce explains, "Letters of credit (LCs) are one of the most secure instruments available to international traders.... An LC is useful when reliable credit information about a foreign buyer is difficult to obtain, but the exporter is satisfied with the creditworthiness of the buyer's foreign bank. An LC also protects the buyer since no payment obligation arises until the goods have been shipped as promised."

A transferable letter of credit includes an additional provision making some or all of the credit that the bank is guaranteeing transferable to another party, known as the secondary beneficiary. The secondary beneficiary might, for example, be a supplier that the seller (the first beneficiary) is relying on to provide the goods that they are selling. In this type of arrangement, the first beneficiary is serving as a sort of middleman between the supplier and the buyer. There can be more than one secondary beneficiary.

Transferable letters of credit, like other credit letters, are used in both domestic and international commerce.

Obtaining a Transferable Letter of Credit

Letters of credit are available from many banks, particularly those with an international presence.

The approval process for letters of credit, both transferable and non-transferable, is similar to applying for a bank loan. The buyer must submit a credit application, including details on their income, assets, and existing debts, as well as the transaction itself. The bank will analyze that information as part of its underwriting process. Underwriting is the procedure banks follow to assess how much risk a particular borrower poses and make a decision on whether to extend them credit—and, if so, at what cost.

With a letter of credit, the borrower isn't taking an actual loan. Instead, the letter of credit guarantees that the bank is willing to issue a loan for a specified amount to the borrower if one is needed to cover the payment promised to the seller.

Transferable Letter of Credit vs. Confirmed Letter of Credit

A transferable letter of credit can be a more convenient option for a buyer than a confirmed letter of credit. That's because the buyer is only required to deal with one bank for a transferable letter of credit.

With a confirmed letter of credit, however, the buyer must obtain two letters of credit, with the second letter guaranteeing the first one. Confirmed letters of credit can be required by a seller in the event that the first bank defaults on repayment. The second bank will typically be a bank that the seller is familiar with. Confirmed letters are common in international trade and may involve banks in more than one country.

The Bottom Line

Letters of credit are an important tool in business transactions between buyers and sellers, especially if the parties are in different countries or have not had a long relationship and built up trust. Transferable letters assure both sellers and their suppliers that they will be paid for their goods and services if they deliver as promised. Buyers must pay for letters of credit, but they often facilitate deals that wouldn't be possible otherwise.