A letter of credit is the lender's promise to pay a named beneficiary, such as a landlord, insurer or overseas supplier, if you do not, or when shipping documents are presented. Under a revolver it is issued inside an LC sublimit, and its full face amount is subtracted from your availability from the day it is issued, whether or not anyone draws on it. If it is drawn, the lender pays and the amount becomes a loan under the line. You pay an annual fee on the face amount while it is outstanding. Size the line for letters of credit as well as borrowings.
- What it is
- The lender's undertaking to pay a third party on stated conditions
- Two kinds
- Standby (a backstop if you fail to pay or perform) and commercial (pays a supplier against documents)
- Effect on the line
- Face amount reduces availability dollar for dollar while outstanding
- If drawn
- The lender pays; you owe it back, usually as a loan under the revolver
- Cost
- An annual LC fee on the face amount, plus issuing-bank charges
What the lender is promising
A letter of credit replaces your credit with your lender's. The beneficiary, whether a landlord, an insurer or a supplier, does not have to judge whether your business will pay; it only has to trust the issuing bank to pay. That is why counterparties ask for them, and why a lender treats every one it issues as money it may have to pay out.
Letters of credit come in two broad kinds, and they behave differently under a revolver.
| Standby letter of credit | Commercial (trade) letter of credit | |
|---|---|---|
| Purpose | A backstop: pays if you fail to pay or perform | The payment mechanism: pays a supplier when goods ship |
| Who asks for it | Landlords, insurers, sureties, utilities, some suppliers and customers | Overseas suppliers, especially on first orders |
| Expected to be drawn? | No; a draw means something went wrong | Yes; that is how the supplier is paid |
| Typical term | A year, often renewing automatically unless the bank gives notice | Matched to the shipment, usually a few months |
| What the draw needs | A demand stating you defaulted, sometimes with a certificate | Shipping and title documents that match the letter's terms exactly |
| What it becomes if drawn | A loan to you under the revolver | A loan under the revolver, repaid as the goods are sold |
The usual requests for a standby letter are predictable: a landlord in place of a large cash security deposit; a workers' compensation or casualty insurer securing a large-deductible or self-insured program; a surety backing bonds for a contractor; a key supplier extending open credit terms; a utility or government licensing body. Commercial letters of credit belong to importers, who use them to pay a foreign supplier that will not ship on open account.
How a letter of credit uses up the line
A revolver's availability is the lesser of the commitment and the borrowing base, less reserves, less everything outstanding. Letters of credit count as outstanding at their full face amount from the day they are issued. Nothing has been lent, and nothing may ever be, but the lender has committed to pay if asked, and it holds room in the line to cover that.
| Line item | Amount |
|---|---|
| Commitment | 5,000 |
| Borrowing base (eligible receivables and inventory, after advance rates) | 4,200 |
| Lesser of commitment and borrowing base | 4,200 |
| Revolving loans outstanding | 2,500 |
| Standby letter of credit to the insurer | 600 |
| Standby letter of credit to the landlord | 300 |
| Availability | 800 |
The owner in that example sees a loan balance of 2,500 against a borrowing base of 4,200 and thinks there is 1,700 to spend. There is 800. The difference is two instruments no one expects to be drawn, and it matters most in exactly the month when receivables are high, inventory is building and the line is stretched. Excess availability covenants usually count letters of credit the same way, so the same 900 can also push a company toward a covenant trigger.
If a letter is drawn, the lender pays the beneficiary and you owe the lender the amount, typically at once. Credit agreements handle this by treating the reimbursement as an automatic revolving loan. Availability does not change, since the letter's face amount is replaced by a loan of the same size, but the balance now carries interest. If the line has no room to absorb it, the draw creates an over-advance: the lender can demand repayment at once, and any time it gives you to cure is a concession, not a right.
What letters of credit cost
The main cost is the LC fee: an annual rate charged on the face amount for as long as the letter is outstanding, usually paid quarterly. Under many revolvers it is set in relation to the line's own interest margin, and it appears in the same pricing grid where one exists. On top of it come the issuing bank's charges for issuing, amending and paying a draw; where the revolver lender is not itself the issuer, a fronting fee goes to the bank that issues.
Two cost points owners miss:
- Unused line fees. Many agreements count letters of credit as usage when calculating the unused line fee, so a letter replaces the unused fee on that slice of the line with the LC fee. Check the definition; some do not.
- Commercial letters and inventory. An importer paying by commercial letter of credit ties up availability from issuance until the goods arrive and enter the borrowing base. Goods at sea may count only inside an in-transit sublimit, if at all, so the letter uses the line for weeks before the inventory it paid for helps support it.
Sizing the line for letters of credit
A revolver that fits cash needs alone will be short whenever letters of credit are outstanding, and standby letters are outstanding all the time. Build them into the sizing from the start.
- List every letter you have or expect: beneficiary, face amount, expiry, renewal terms. Insurers commonly reset the amount each policy year as claims develop; landlords set it once in the lease.
- Add them to the peak. The sizing method finds the peak month of borrowing need. Letters of credit sit on top of that peak, not beside it.
- Check the LC sublimit. Every revolver caps letters of credit within the commitment. A sublimit set too low for your insurer's program forces a separate facility or cash collateral.
- Watch the renewal dates. A standby letter that renews automatically has to fit within the revolver's own term; lenders do not like letters that outlive the facility.
Letters of credit are not borrowings, but they consume the line. Size the facility for letter-of-credit usage as well as cash needs, and confirm the sublimit fits before signing.
Letters of credit when you refinance or leave a line
Outstanding letters of credit are the part of a revolver that cannot simply be paid off. The beneficiary holds an irrevocable instrument from the old lender, and it will not hand it back until it has a replacement it likes. When a line is refinanced, the options are:
| Option | How it works | Watch for |
|---|---|---|
| Replace | The new lender issues new letters; beneficiaries return the old ones for cancellation | Beneficiaries must accept the new issuer, and return the old letter promptly |
| Backstop | The new lender issues a letter to the old lender, covering the old letters until they expire | Paying two sets of fees for a period |
| Cash collateralize | You deposit cash with the old lender until each letter expires or is returned | Lenders usually ask for more than the face amount, so it ties up cash |
The payoff letter from the exiting lender will state how it wants outstanding letters handled, and the closing cannot fund until that is agreed. Raise it early: an insurer's letter of credit is often the slowest piece of a refinancing closing, because the insurer's own approval process governs the swap.
Preparing the file
Alongside Transparent's line-of-credit checklist (an AR aging by customer, an AP aging, the balance sheet and P&L, a debt schedule and UCC position, and an inventory report where inventory is in the base), list every letter of credit outstanding or planned, with the documents that call for it: the lease clause, the insurance program's collateral requirement, the supplier's terms. A lender sizing the sublimit needs to see the obligation, not just the amount.
Transparent models availability with the letters included, month by month, so the line proposed covers the peak with them outstanding. The book holds 235 lenders that write asset-based loans and lines, and their appetite for letter-of-credit-heavy facilities varies a good deal; importers and companies with large insurance programs benefit most from comparing them.
Common questions
- Does an undrawn letter of credit count as debt?
- It reduces availability under the line in full. For covenants it depends on the credit agreement's definition of funded debt: many exclude undrawn standby letters and include drawn ones. On the balance sheet, an undrawn letter is a contingent obligation disclosed in the notes rather than a liability.
- Can I get a letter of credit without a line of credit?
- Yes, if you secure it with cash. A bank will issue a standby letter against a deposit it holds, which ties up the cash but leaves any revolver untouched. It is a common choice for a single large landlord or insurer letter.
- What happens if my landlord draws on the letter?
- The lender pays the landlord and your line records a loan for the same amount, which then carries interest. The draw itself reveals a dispute or default the lender will ask about, so tell the lender before a beneficiary is likely to draw.
- Why is my LC sublimit smaller than my line?
- Lenders cap letters of credit because they commit the lender to pay third parties on terms the lender does not fully control. Negotiate the sublimit to your listed needs with some room; raising it later requires an amendment.
- What is an evergreen letter of credit?
- One that renews automatically each year unless the issuer gives notice of non-renewal a set time before expiry. Insurers and landlords commonly ask for it. The notice is the beneficiary's cue to draw, so lenders manage it carefully.