Bank guarantee vs letter of credit: differences, costs and which one to use

Bank guarantee vs letter of credit in one line

A letter of credit (LC) is how a buyer pays a seller safely. A bank guarantee (BG) is how a business backs its promise to someone else. In both, a bank puts its name behind a customer. That is why banks regulate both as the same family, called non-fund based facilities (RBI notification).

The difference is when the bank pays. Under an LC, it pays when the seller shows documents that comply with the credit, which is the normal course of the deal. Under a BG, it pays only if its customer fails, which is the exception. ICC puts it this way: demand guarantees and standby credits "represent a secondary obligation covering default only", unlike a documentary credit that pays on performance (International Chamber of Commerce).

Side-by-side comparison

When to use a letter of credit

Choose an LC when the problem is getting paid for a sale:

• you sell to a buyer you do not know well, or in another country;
• you want a bank's promise to stand behind a shipment; or
• the buyer wants proof of shipment before money leaves.

The seller carries the document work. The LC pays only against papers that match its terms, so even a small mismatch can stall payment. The how a letter of credit works page walks through the steps.

When to use a bank guarantee

Choose a BG when the problem is proving you will perform or pay:

• a tender authority wants a bid bond before it takes your bid;
• a buyer pays you an advance and wants cover until you deliver;
• a contract needs a performance guarantee; or
• a landlord or utility wants a guarantee instead of a cash deposit.

The types of bank guarantee page covers performance, financial, bid and advance payment guarantees.

Where they overlap: the standby letter of credit

A standby letter of credit, or SBLC, is an LC that works like a guarantee. It is not drawn in the normal course. It pays only if the applicant defaults, and the beneficiary claims with a statement of default (International Chamber of Commerce). Some beneficiaries abroad prefer a standby because the rules for standbys are familiar to them. In India, a bank guarantee is more common for domestic contracts. Your bank will tell you which it issues for your case.

What do they cost?

Both are priced as a commission for the promise. Each bank sets its own card. Here is one public sector bank's published card for borrowers that are not large corporates. It shows an effective date of 10-Dec-2022 and is an example, not an offer.

On ₹10,00,000 for an unrated MSME, that works out as (Bank of Baroda):

• a sight LC at ₹7,000;
• a 120-day usance LC at about ₹4,932;
• a one-year performance guarantee at ₹20,000; and
• a one-year financial guarantee at ₹26,500.

These are arithmetic on one bank's card, not quotes. ICICI Bank publishes a ceiling of up to 2% a year for LCs and bank guarantees (ICICI Bank). Your bank decides your figure. The bank guarantee charges page has more, and the letter of credit page has the LC extras such as confirmation and discrepancy fees.

Who can get either one?

For both, RBI's directions say a bank should, in general, issue a non-fund facility only for a customer that has a funded credit facility with it. The listed exceptions are a facility fully secured by eligible financial collateral, one issued against a no-objection certificate from the lender that funds you, and one for a customer with no fund-based facility from any lender in India (RBI notification).

So in practice a bank sanctions the limit as it would for a loan. It looks at your repayment record, cash flow and security. Both instruments tie up part of your credit limit while they are live, so they compete with your working capital for headroom.

How to choose

1. Ask who needs comfort. If the seller needs comfort that it will be paid, think LC. If the buyer or authority needs comfort that you will perform, think BG.
2. Ask what triggers the payment. If shipping documents do, think LC. If a failure does, think BG or standby.
3. Ask who can bear the document work. LCs demand strict papers.
4. Compare the bank's commission card, margin and release terms.

Capnix does not issue LCs or guarantees. Banks do. Capnix can take a trade requirement to the lenders on our lender panel. See the trade finance product page, or start with the free loan readiness check and a Capnix score from 0 to 100. The trade finance hub lists the other instruments.