In our previous entries, we covered half of the importation process: choose a product, pick a country, find a supplier, and hammer out a sales agreement with him. But before your products can be shipped to you, you need to make a payment to the seller. As mentioned from the beginning, international money transactions tend to be complicated, which is why we’re dedicating a whole entry to explain the different payment methods you might see in global trade.
In international agreements, it is common to use methods that give the seller a certain level of protection. This is because if the buyer decides to skip out on the payment, it is more difficult for the seller to travel to the buyer’s country, file a lawsuit, and make the other party pay. Usually the seller would agree to a less-than-secure method only if the buyer has already established a good purchasing history, or if the buyer has great bargaining power (for example, if the buyer is a major name in retail and the seller does not want to lose the chance to supply such a big client). The five methods we discuss here are presented in the ascending order of buyer’s security. Remember, the more secure it is for the buyer, the less it is for the seller.
Wire-transfer: this method is the most direct. All you need your supplier’s bank account information and you can instruct your bank to transfer the money. Suppliers like this method the most and they usually require you to wire-transfer when you purchase on a trial basis, place small orders, or if you do not have any purchase history with them. However, this is also the least secure for buyers since once the money is transferred, there is not much you can do if the product delivered differs from what you ordered. (That is why choosing a supplier is so important, we cannot stress that enough!)
Letter of credit: a letter of credit can be understood as the bank’s guarantee of the buyer’s payment. This is how it works: the seller will require the buyer to obtain a letter of credit issued by the buyer’s bank (sometimes the seller will have his bank verify the validity of this letter). To eliminate any confusion, the seller will tell the buyer exactly how he wants the buyer’s bank to issue the letter of credit in a document called the letter of credit instruction. At the time of shipment, the ocean carrier will give the seller a Bill of Lading (a document that defines the ownership and title passage of the goods). To retrieve his payment, the seller will submit this bill of lading as a proof that he has shipped the goods along with a copy of a commercial invoice, and the letter of credit to his bank.
Documentary Collection – Documents against Payment (D/P or Sight Draft) and Documents against Acceptance (D/A or Time Draft): this method is similar to letter of credit in the sense that payment collection is done through bank services. The difference in this case is there is no guarantee of the buyer’s payment. A draft (sometimes is also called a bill of exchange) is an instrument that is both drawn up by and made payable to the seller. When it is accepted by the buyer, it has the same value as a check written by the buyer to the seller.
How D/P and D/A work are demonstrated below, and you can download the pdf version here:
The main difference between them is that if using D/P, or sight draft, the buyer has to make payment before the documents (bill of lading) is released to him. If he fails to pay, he will not get the goods. If using time draft, the buyer has a certain period of time to make payment upon his acceptance of the goods.
Sale on Open Account: This is the best method for buyers, but since it involves a lot of risk for sellers, sellers only agree on this method with big importers. Upon shipping the goods, the seller will send the bill of lading and commercial invoice directly to the buyer; therefore, the buyer can always retrieve the shipment whether or not payment is made.
To summarize, there are five payment methods that can be used in international trade. Each of these methods involve different level of risks for sellers and buyers. Sellers always want to secure their payment as soon as possible, while buyers want to make sure they get what they ordered before making any payment. The two parties will have to agree on one of the payment methods, but which one will depend on the relationship between the seller and buyer, the size and frequency of the order, and the seller’s and buyer’s reputation.