A letter of guarantee is a type of contract issued by a bank on behalf of a customer who has entered a contract to purchase goods or services from a supplier. The letter of guarantee assures the supplier that they will be paid even if the customer of the bank defaults on payment. Letters of guarantee are often used when one party in a transaction is uncertain that the other party involved can meet their financial obligation, especially in the case of purchases of costly equipment or other property.

A letter of guarantee is different from a commercial letter of credit, which commits the bank to pay the supplier directly on behalf of the customer when the services are rendered, whether the customer has the ability to pay or not. To get a letter of guarantee for one of their suppliers, a company must apply to their bank just like any other loan application. If approved, the bank essentially transfers its credit rating to the company, so the supplier company can rely on it for payment.

Letters of guarantee are used in a wide variety of business situations, including contracting and construction, financing from a financial institution, or declarations during export and import processes. A letter of guarantee may also be issued in technology trade, large equipment leases, and goods import-export declaration. It may also be issued if requested by a call writer to give a guarantee that they own the underlying asset and that it will be delivered by the bank if the call is exercised.

The amount guaranteed by the letter does not appear on the company’s balance sheet but is noted as a contingent liability. As long as the company is able to cover its expenses, it won’t actually require the bank to pay any of its bills, which is why a letter of guarantee is also known as a “standby loan.” Companies pay an annual fee but no interest for this privilege. The fee is usually a percentage of the total amount guaranteed by the letter.