The letter of credit and the promissory note typically give the same promise - the promise of funds. While each is a written instrument commonly used in financial transactions, each serves a different function. In essence, the letter of credit promises something the issuer already has, while the promissory note promises to give something in the future that the issuer may not yet have.
History of the Letter of Credit
Around the 14th century, European bankers devised a way of transporting money, known as the letter of credit, which might be the precursor to the credit card. Instead of a plastic card, the letter of credit was an actual letter, written by the bank on behalf of a customer, stating the amount of credit the holder of the letter had with the financial institution. A person could use the letter of credit to make a purchase because funds promised by way of the letter of credit were funds the holder of the letter already had approval to use.
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Letter of Credit Today
While credit cards provided a new way to transport funds, they did not replace the letter of credit. International business transactions involving large sums of money often rely on the letter of credit as the funding instrument. The process for redeeming the funds may vary but typically require documentation or receipt of goods or services.
While the letter of credit promises funds that the holder has access to, the promissory note is basically an IOU. It is the personal promise from the borrower to repay a loan. By issuing a promissory note, the borrower exposes his assets to the lender. A promissory note is transferable, in that a lender who receives the note can sign it over to a third party.
Promissory Note Function
A mortgage is a lien on property held by the lender or mortgagee. When establishing a mortgage, the borrower first issues a promissory note to the lender pledging the real property as collateral should the borrower default. The promissory note is the instrument used to convey the borrower's promise, while the mortgage is the instrument used to enforce the promise.
An important distinction between a promissory note and a letter of credit is how it applies to the receiver. The receiver of the promissory note typically supplies funds for a purchase. The receiver of the letter of credit is not the party supplying funds for a purchase, but the party receiving the funds.