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After all the work that goes into applying to college — researching schools, submitting transcripts, taking entrance exams, and writing essays — students probably welcome a feeling of relief once that application is officially submitted.

The relief may be instant, but also fleeting. The next phase of getting into college can be painstaking because it’s the waiting phase. Acceptance letters don’t have one standard date for being sent out. Admissions decisions can be delivered as early as December for early action or early decision applicants and as late as April for regular admission applicants.

Learn more on different types of college admissions applications and see how their submission deadlines and acceptance date periods differ.

Types of Applications

Just as there isn’t a standard date for acceptance letters to be sent out, there isn’t one standard submission date for applications, either. There are a few early submission options available, as well as regular submission and rolling admissions. The due date of the application will depend on which type of application is being submitted, and this will also determine when you receive the school’s decision.

Options for applying early include early decision, early action, and single-choice early action.

Early Decision

The early decision application is binding, meaning that students who are accepted are committed to enrolling. Because this application is binding, students can only apply to one school as an early decision. These applications are due in November and the decisions go out in December. If students decide to apply with this early decision option, this school should be their top choice and the one they’d prefer to go to over all others.

Early Action

The early action application is similar to the early decision in regard to the due date (due in November) and decision timeframe (decisions go out in December), but it differs in that it isn’t binding. It’s okay to apply to multiple schools via early action, and if you’re accepted you’re not required to enroll until the normal reply date of May 1.

Recommended: Early Action vs Early Decision

Single Choice Early Action

This option is similar to the early decision in that students can only apply to one school this way, but it’s not binding. If students choose to apply to a school via single-choice early action, it’s a way of saying they’re especially interested in attending that school. The deadline and acceptance period is the same as the other early options.

When it comes to applying early, no matter which type of early application you choose, the applications will usually be due in November and decisions will be sent out in December.

Regular Decision

Regular decision college applications are the most common of the application options. For these applications, the deadline is usually in January or February and the decision letters go out by April. The deadline for submitting your application will differ between schools, so make sure to check the website for each school and mark the dates on a calendar.

Recommended: Ultimate College Application Checklist

Rolling Admission

Rolling admission allows students to apply until the school runs out of space. Applications may be accepted until April or later. Students are encouraged to apply using the same deadline as the regular decision, though, to have a better chance of being accepted before the colleges run out of spaces.

Some colleges will also have differing numbers of spots open based on specific majors. If the major the student lists on an application is impacted at some schools, it might be better to apply by the deadline for regular applications since impacted majors are likely to have more students apply than there are spots available. The average turnaround for rolling admission is about four to six weeks, so the date that decisions are sent out will depend on when students submit their application.

Recommended: College Search – College Finder Tool

The Dreaded Waitlist

After waiting for one to two months to receive a school’s decision, it can be frustrating to open that letter or email and see that there’s more waiting to do. Being on the school’s waitlist isn’t necessarily bad, however.

There are many reasons that students end up on the waitlist. They may have met the academic criteria to get into the school, but the school might not have space yet for these students.

Most schools will require students to contact them and accept their spot on the waitlist to be considered for admission, so don’t forget that step.

Since the number of students that can be accepted from a waitlist depends on the number of students who choose to enroll, students on the waitlist won’t hear back until after decision day.

Decision day is May 1, and it’s the day that seniors are required to notify their school that they accept their admission and will enroll.

After the decision day, the schools will know how many students will enroll, and then they’ll be able to start accepting students from the waitlist if there’s space. This means students on the waitlist can expect to hear back from their school by the end of May, but sometimes it can take up until the fall semester starts to hear back.

Paying for College

Planning for college goes beyond getting accepted. Once accepted, students have to figure out how to pay for college, including tuition, books, and housing. Luckily, there are many good options for financing higher education, which can include financial aid from the government (grants and/or loans), scholarships, and private loans.

Recommended: Ca$h Course: A Student’s Guide to Money

Financial Aid

The Free Application for Federal Student Aid (FAFSA®) is the form students will need to complete as the first step in applying for student aid. Depending on a student’s Student Aid Index (SAI), they may be eligible for federal student loans, grants, or work-study.

Grants don’t usually have to be repaid, but loans do. The amount of aid students can receive from the federal government will depend on their financial need, so not everyone will be eligible.

Recommended: What Is the Student Aid Index?

Federal Student Loans

Federal student loans come with some benefits that are not guaranteed by private student loans, like lower fixed interest rates and flexible repayment options. Federal loans also offer borrower protections, such as deferment and forbearance, and student loan forgiveness programs for those that qualify.

Scholarships

Scholarships can be merit-based, meaning they’re awarded based on some kind of achievement, or need-based. There are many scholarships available, and it’s perfectly acceptable to apply to as many as possible to further the chances of receiving one — or more. Some scholarships are specific to a school or the local community, so check your school’s website for information.

Private Student Loans

Private student loans may be another option for paying for college. Since every financial institution is different, do some research and explore options available. Loan amounts and rates will depend on an applicant’s financial situation, including their credit history and income. Those with little of either may need a cosigner to be approved for a private loan.

Even if the cost of attendance might be covered by scholarships, grants, or federal student loans, there may be other costs of living a student might need assistance for. That’s where private student loans can be helpful when considered responsibly.To learn more about private student loans, college-bound students might want to check out this guide to private student loans.

Keep in mind, though, that private student loans do not offer the same protections as federal student loans, so it’s best to explore federal loans before relying on private ones.

The Takeaway

It can take a few weeks to a few months to hear back for a college admissions decision, depending on the type of application you submitted. Early applicants — such as early decision or early action — will generally hear back in December while regular decision applicants will receive their admission decision in April.

Taking some time to think about college costs and how to pay for the upcoming years of education can be a wise way to spend that time waiting for all of those acceptance letters to come rolling in. Options for paying for college include cash savings, grants and scholarships, federal student loans, and private student loans.

If you’ve exhausted all federal student aid options, no-fee private student loans from SoFi can help you pay for school. The online application process is easy, and you can see rates and terms in just minutes. Repayment plans are flexible, so you can find an option that works for your financial plan and budget.

FAQ

How long does it take to hear back after applying to college?

It usually takes four to six weeks to hear back after applying to college, depending on the school’s admissions process and the type of application. Early decision applicants may receive a response in November or December, while regular decision applicants typically hear back between March and April.

What’s the difference between early decision and early action?

Early decision is a binding agreement where, if accepted, you must attend the college, while early action is non-binding, allowing you to apply to multiple schools and decide later.

Do colleges send rejection letters?

Yes, colleges send rejection letters to applicants who are not accepted. These letters are typically sent around the same time as acceptance letters, either by mail or email, depending on the school’s process.

SoFi Private Student Loans
Please borrow responsibly. SoFi Private Student Loans are not a substitute for federal loans, grants, and work-study programs. You should exhaust all your federal student aid options before you consider any private loans, including ours. Read our FAQs. SoFi Private Student Loans are subject to program terms and restrictions, and applicants must meet SoFi’s eligibility and underwriting requirements. See SoFi.com/eligibility-criteria for more information. To view payment examples, click here. SoFi reserves the right to modify eligibility criteria at any time. This information is subject to change.

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOISL-Q324-042

When you rent an apartment or home, you typically need to provide a security deposit, often equal to one month’s rent, or the first and last month’s rent. This is cash the landlord sets aside to cover the cost of any damage you might do to the property or recoup any unpaid rent. You get it back (assuming you keep up your end of the rental agreement) when you move out. In the meantime, though, you have to come up with the cash.

If you don’t have the potentially thousands of dollars you need to secure a rental just sitting in the bank, you might consider taking out a security deposit loan. This is a type of personal loan that can give you quick access to the funds needed to secure a rental. However, these loans come with costs, as well as some other drawbacks. Here are key things to know about security deposit loans.

Understanding Security Deposit Loans

Definition and Purpose

A security deposit loan is a type of personal loan specifically structured to help renters cover the cost of their security deposit when moving into a new rental property. However, even if a personal loan isn’t specifically marketed as a “security deposit loan,” you can likely use it for this purpose. Unlike a mortgage or car loan, personal loans aren’t tied to a specific use. They’re a form of flexible funding that you can use for a wide variety of expenses, including covering the security deposit on a rental, or even to purchase new furniture for your new place.

How Security Deposit Loans Work

Personal loans for apartment deposits are available from banks, credit unions, and online lenders. They are a type of installment loan: You receive the full amount of the loan upfront, then repay it (plus interest) in monthly installments over the term of the loan.Security deposit loans typically have fixed interest rates, which means that the interest rate — and your monthly payment amount — will remain the same throughout the life of the loan.

Most personal loans are unsecured, so you don’t need to provide an asset of value (called collateral) to back up the loan. There are some secured personal loans, however, which do require collateral. If you opt for a secured loan, the lender can seize your collateral if you default on your payments. Since this lowers the lender’s risk, secured loans typically have lower interest rates and can be easier to qualify for than unsecured loans.

Eligibility and Requirements for Security Deposit Loans

If you are wondering if you can get a loan for a security deposit, here’s a look at common criteria for approval.

Credit Check and Income Verification

When you apply for a security deposit loan, the lender will typically perform a credit check to assess your past borrowing behavior (a.k.a., creditworthiness). You can often prequalify for a security deposit loan, which involves a soft credit pull and won’t impact your credit. When you officially apply, however, the lender will do a hard credit check, which can temporarily lower your score by a few points.

A positive credit history and solid credit score increase your chances of approval and may result in more favorable loan terms, such as a lower interest rate. While there’s no universal minimum credit score for a personal loan, many lenders like to see a credit score of at least 580.

Lenders also require proof of income to ensure that you have the financial means to repay the loan. This can include recent pay stubs, tax returns, and/or bank statements. Some lenders may also consider the applicant’s employment history and stability as part of the approval process.

Repayment Term and Interest Rate

Repayment terms for security deposit loans can vary widely depending on the lender and loan amount, but commonly range from six months to three years. The rate you’ll pay will depend on the lender, the loan amount, and your creditworthiness as a borrower. The average personal loan interest rate as of July 2024 is 12.36%.If you have good or excellent credit, you may get a lower interest rate; if you have poor credit, the rate could be higher.

Additional Fees and Costs

Security deposit loans may also come with fees. Some lenders charge an origination fee to cover the cost of processing the loan. These are often between 1% and 5% of the loan amount but can be as high as 10%.

Other fees you may see tacked onto a security deposit loan include late fees (which you’ll only pay if you don’t make a payment on time) and a prepayment penalty (a fee for paying off your loan early).

Not all lenders charge fees, and in some cases you may be able to negotiate with your lender for lower fees or to have them waived entirely.

Pros and Cons of Security Deposit Loans

As with any form of financing, apartment deposit loans have both benefits and drawbacks. It’s important to understand both so you can make an informed decision. 

Advantages of Security Deposit Loans

•  Can secure the rental: If you don’t have sufficient savings to cover your security deposit, a security deposit loan can make the difference between getting — and not getting — the rental apartment or home you want.

•  Fast access to cash: Many personal loan lenders offer funding within two to five business days after approval. Some even fund the loan the same day you’re approved.

•  Can help you build credit: Making on-time payments on a security deposit loan can help you build a positive credit history. Adding an installment loan to your credit mix can also have a positive impact on your credit.

•  Spreads out costs: By repaying the loan over time, renters can spread out the cost of the security deposit, making it easier to manage.

•  Don’t have to resort to other forms of financing: You won’t need to rely on more expensive forms of financing, such as a payday loan or a credit card cash advance.

Drawbacks and Risks

•  Increases your costs: Taking out a personal loan to cover your security deposit ultimately makes that deposit more expensive. Even if you get the full amount back from the landlord when you move out, you won’t recoup the interest and fees you paid for the loan.

•  Added financial responsibility: Once you take out a loan, you’ll be on the hook for keeping up with loan payments. That’s another bill to pay – on top of your new rent and other monthly costs.

•  It could potentially hurt your credit. Missing payments or defaulting on a security deposit loan can negatively impact your credit, making it more difficult to secure loans or credit cards with low rates in the future.

•  It may be a sign that you’re not ready to move. Going into debt to pay for a security deposit may indicate that you aren’t ready for financial independence. You might consider more affordable rental properties, partnering up with roommates, or living with family until you can save more.

•  Eligibility requirements: Not all renters will qualify for a security deposit loan, especially those with poor credit or an unstable income.

Alternatives to Consider

If taking out a loan for an apartment deposit doesn’t make financial sense for you, here are some other options to consider.

•  Saving up: Planning and saving for a security deposit in advance can help avoid the need for a loan. Consider setting up an automatic transfer from checking to saving for a set amount each month to build your moving fund. To fast-track your savings, you may want to cut back on expenses and/or look for ways to bring in more income. 

•  Applying for a rental with a smaller security deposit: Some landlords only request one month’s rent (rather than first and last), which could make it easier to cover the deposit without taking on debt. 

•  Negotiating with the landlord: Some landlords may be willing to negotiate the security deposit amount or offer a payment plan, allowing renters to pay the deposit in installments rather than a lump sum.

•  Borrowing from family or friends: Borrowing from trusted family members or friends can be a cost-effective alternative, often without the interest and fees associated with loans.

•  Getting a roommate: This will allow you to split the security deposit, as well as other moving costs, not to mention the rent moving forward. 

Recommended: Personal Loan Versus Credit Card

The Takeaway

Taking out a security deposit loan to cover the deposit on a new rental can be a relatively easy way to come up with the money you need to get the keys and move in. However, you’ll need to weigh the pros and cons of taking on debt. 

It might be better to assess whether you’re financially ready to make the move or consider other ways to raise the cash. If you decide that using a personal loan for a security deposit makes sense for your situation, you’ll want to shop around for the best possible deal and be sure to manage the loan responsibly. 

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.

FAQ

Are security deposit loans only for apartments?

No, security deposit loans are not limited to apartments. They can generally be used for any rental property that requires a security deposit, including single-family homes, condos, and townhouses. The primary purpose of these loans is to help renters cover the upfront cost of the security deposit, regardless of the type of rental property. However, you’ll want to check with the lender to ensure that the loan terms align with your specific rental situation.

What happens if I move out before repaying the loan?

If you move out before repaying a security deposit loan, you’re still financially responsible for making the agreed-upon payments until the loan is paid in full. The loan is a separate financial obligation from your rental agreement, meaning that moving out does not clear your debt.

Can I use a security deposit loan for a home purchase?

No, security deposit loans (which are a type of personal loan) are specifically designed for rental properties and are not meant to be used for a down payment on a home. In fact, many mortgage lenders forbid you to use a personal loan to cover a down payment for a home, since this involves taking on two debts at once.

Photo credit: iStock/Happy Kikky

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

Non affiliation: SoFi isn’t affiliated with any of the companies highlighted in this article.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOPL-Q324-001

When taking out a personal loan, one of the key decisions you’ll have to make is what term to select. A loan’s repayment term (i.e., how long you have to pay it off) can significantly impact your monthly payments, the total amount of interest you pay, and how quickly you become debt-free. Understanding how different term lengths affect loan repayment can help you make an informed choice that aligns with your budget and financial goals.

Below, we walk you through how personal loan term lengths work, and the pluses and minuses of going with a shorter- versus a longer-term loan. 

What Does Personal Loan Term Length Mean?

Put simply, the term length of a personal loan is how long you have to pay it off. More specifically, it’s a period of time that starts when you receive the loan funds and ends when your final payment is due. 

Personal loan terms vary depending on the lender and the amount of the loan, but typically range from two to seven years. Lenders will often give you a choice of loan terms. The length you choose will determine your monthly payment amount and the total amount of interest you’ll pay over the life of the loan. It can also impact the interest rate you’ll pay.

How Do Personal Loan Terms Work?

When you take out a personal loan, you’ll receive the full amount of the loan (called the principal) up front. Typically, you need to start paying back the principal, plus interest, in monthly installments within 30 days. These monthly payments will continue throughout the term of the loan. 

Generally, the larger the loan, the longer the term will be. For example, a $500 personal loan will often have a term of one year or less, while a $15,000 loan might have a three- to four-year term. Loans of $30,000 or more can have terms ranging from five to seven years.

Recommended: How Personal Loans Work

Factors to Consider When Choosing a Personal Loan

There are a number of things to consider when taking out a personal loan. These include:

•   Loan amount: It’s important to take out a loan that’s enough to cover your needs but not more than you’ll need, since you’ll be paying interest on these funds. While you can find personal loans as small as $500, many lenders have loan minimums of $1,000 to $2,000.

•   Interest rate: Rates for personal loans can range anywhere from 5.99% to over 29.99%. The rate you’ll pay will depend on the lender, the loan amount, the loan’s term, and your credit score. Generally, you’ll get a lender’s lowest rate if you have a good or excellent credit score and select the shortest available term.

•   Repayment term: The less time you’re in debt, the less time interest has to accrue. Thus, going with a shorter loan term can lower the overall cost of a personal loan. However, it means your monthly payments will be higher. Repayment terms can also impact personal loan rates, with longer terms typically linked to higher rates, since they pose more risk to the lender.

•   Collateral: Personal loans are typically unsecured, which means you don’t have to pledge a valuable asset (collateral) to back up the loan. There are some secured personal loans, however. Since collateral lowers a lender’s risk, secured loans tend to have lower interest rates than unsecured loans. However, should you fall behind on payments, the lender can seize your collateral to recoup their losses.

•   Origination fee: Some lenders charge origination fees to cover the processing costs of the loan. These fees can range from 1.00% and 8.00% of the total loan amount. In some cases, you need to pay this fee in cash at closing; in others, the lender adds it to the amount you’re financing or subtracts it from your loan before it’s dispersed. Some lenders, however, don’t charge origination fees for personal loans.

•   Prepayment penalty. If you pay off your personal loan early, a lender might charge you a prepayment penalty to make up for the loss in interest. But not all lenders charge a prepayment penalty.

Pros of Short Term Loan Length

Here’s a look at some of the advantages of taking out a personal loan with a shorter repayment term.

Faster Debt Repayment

One of the main advantages of a short-term loan is that you can become debt-free more quickly. By committing to higher monthly payments, you reduce the loan balance faster, which can free up your income for other uses sooner.

Lower Total Interest Costs

Because you are paying off the loan more quickly, there is less time for interest to accrue. As a result, shorter-term loans typically result in lower total interest costs, saving you money in the long run.

Potential for Lower Interest Rates

Since shorter terms reduce risk to the lender, you may be able to get a lower interest rate by choosing a shorter loan term. This can further decrease the overall cost of the loan.

Cons of Short Term Loan Length

Short-term personal loans also have some downsides, Here are some to keep in mind.

Larger Monthly Payments

One of the main drawbacks of a short-term loan is that you’ll have higher monthly payments. This might be challenging if your budget is already tight. It also means you’ll have less money to save and invest. 

Less Financial Flexibility

With higher monthly payments, there is less room in your budget for unexpected expenses. This can be problematic if you encounter financial difficulties or need to redirect funds for emergencies.

Smaller Loan Amounts

Short-term personal loans tend to be for smaller amounts and may not be sufficient to cover your expense.

Recommended: How Much of a Personal Loan Can I Get?

Pros of Long Term Loan Length

Here’s a look at some of the advantages of choosing a personal loan with a longer term. 

Smaller Monthly Payments

A longer term spreads the repayment over a more extended period, resulting in lower monthly payments. This can make the loan more manageable, especially if you have a tight budget or your income fluctuates.

Frees Up Funds

Lower monthly payments give you more flexibility in your budget, freeing up funds for other goals, such as saving, investing, or covering other expenses. This can be beneficial if you anticipate future financial needs or want to maintain a comfortable lifestyle while repaying the loan.

Larger Loan Amounts

Longer-term personal loans typically give you access to larger loan amounts. This can work well if you have a big expense, such as consolidating credit card debt, a wedding, or a home renovation.

Cons of Long Term Loan Length

There are also some disadvantages to going with a longer loan term. Here are some to keep in mind.

Higher Costs

While longer terms generally make monthly payments smaller, extending the time you take to repay a loan typically leads to higher overall interest costs.

Extended Debt Duration

A longer loan term means you’ll be in debt for many years. This prolonged commitment could potentially become a drag on your budget or impact your financial planning, such as saving for retirement or other long-term goals.

Recommended: What Happens If You Default on a Personal Loan?

Potential for Higher Interest Rates

Longer terms lead to increased risk for lenders. As a result, they may charge higher interest rates, which can further increase costs.

Choosing the Best Loan Term Length

When deciding on the best term length for a personal loan, you’ll want to factor in your monthly budget, financial goals, and the total cost of the loan. Here are some tips to help you decide on the best term length for a personal loan.

•   Assess your financial situation: You might start by taking a look at your current monthly income, expenses, and savings targets. From there, you can determine how much you can afford to pay each month without compromising your lifestyle or future goals.

•   Compare interest rates: It’s a good idea to shop around for lenders offering the best interest rates for different term lengths. A slightly higher interest rate might be acceptable if it results in more manageable monthly payments.

•   Calculate total costs: There are online calculators that can help you compare the total interest paid for different term lengths. Understanding the long-term cost implications can help you make an informed decision.

•   Consider flexibility: Check if the loan allows for early repayment without penalties. This flexibility can be handy if your financial situation improves and you want to pay off the loan faster.

The Takeaway

The right personal loan term length for you will depend on several factors, including your budget and future goals. Generally, going with a shorter term makes sense if you can afford a higher payment, want to save money on interest, and prefer to get out of debt quickly. However, you might be better off with a longer term if you need a more affordable monthly payment and want more flexibility, since you can typically pay your loan off ahead of schedule (just watch for any prepayment fees). 

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.

FAQ

Can personal loans be 10 years?

Yes, personal loans can have terms up to 10 years, although they are less common. Long-term personal loans typically range from two to seven years, but some lenders offer 10-year terms for specific purposes or higher loan amounts. 

While a 10-year term can provide lower monthly payments, it often results in higher total interest paid over the life of the loan. Before you sign a long-term loan agreement, you’ll want to carefully consider the total cost and your ability to commit to such an extended repayment period.

Is it OK to pay off a personal loan early?

Yes, it’s generally okay to pay off a personal loan early, and can even be beneficial. Paying off your loan ahead of schedule can save you money on interest and free up money for other goals. 

However, it’s important to check your loan agreement for any prepayment penalties. Some lenders charge fees for early repayment to compensate for the lost interest. If there are no penalties or the savings outweigh the fees, early repayment can be a smart financial move.

Do personal loans hurt your credit?

Personal loans can have both positive and negative impacts on your credit. Initially, applying for a loan results in a hard inquiry, which can temporarily lower your credit score. Taking on new debt may also affect your credit utilization ratio.

However, consistently making on-time payments can benefit your credit over time by demonstrating responsible credit behavior. Taking out a personal loan may also diversify your credit mix, which could also positively impact your credit. The key is to manage the loan responsibly and avoid missing payments to maintain or improve your credit profile.

Photo credit: iStock/Pekic

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

Non affiliation: SoFi isn’t affiliated with any of the companies highlighted in this article.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOPL-Q324-002

A letter of credit is a document from a bank or financial institution guaranteeing that a buyer’s payment to a seller will be made on time and for the correct amount. As part of a sales agreement, a seller may require the buyer to deliver a letter of credit before a deal takes place.

Letters of credit are often vital in international trade where the two parties involved are not yet familiar with one another. Letters of credit facilitate new trade and prompt payments.

Read on to learn more, including:

•   What a letter of credit is

•   How a letter of credit works

•   What the different types of letters of credit are

•   The pros and cons of letters of credit

•   How to get a letter of credit.

What Is a Letter of Credit in Banking?

A letter of credit in banking is a document that a bank issues to a seller that guarantees payment from their customer for an order or service. The bank where the buyer’s business account is held usually assumes responsibility for the payment for the goods. However, the conditions laid out in the letter of credit must be fulfilled. If the buyer is unable to fulfill the purchase, the bank must pay the seller the purchase amount. The bank or financial institution charges the buyer a fee for guaranteeing the payment and issuing the letter.

Letters of credit are common in international trade situations because various factors can affect cross-border transactions. For example, the deal might involve different legal frameworks, a lack of familiarity between the parties involved, and geographic distance.

If you are a buyer who is planning to be involved in international trade, you will likely want to open a bank account that can provide you with a letter of credit when you need it.

How a Letter of Credit Works

When used properly, letters of credit can work to minimize credit risk and help international trade go smoothly. A vendor selling products or services overseas may want assurance that a buyer of their products or services will pay. Perhaps the buyer is new to them or just a new business, period.

So how does a letter of credit work? It serves as a guarantee from a bank that payment will be made to the vendor once the requirements are met. The letter lays out the conditions of payment, such as the amount, the timing of the payment, and the delivery specifications. The letter may help the business placing the order build their credit, too.

The bank charges the buyer a fee for issuing a letter of credit (often around 0.75% to 1.5% of the amount of the deal). It also does the due diligence to verify the buyer’s creditworthiness. The bank requires collateral or security from the buyer for the payment guarantee. In essence, the bank acts as a third party facilitating the deal.

Recommended: Why is Having a Good Credit Score Important?

Types of Letters of Credit

Here are four types of letters of credit.

•   Commercial Letter of Credit: This is a method in which the issuing bank pays the seller directly. For a stand-by letter of credit, which is a secondary method of payment, the bank only pays the seller if the buyer cannot transfer funds.

•   Revolving Letter of Credit: With this type of letter of credit, the bank guarantees payment for a number of transactions, such as a series of merchandise shipments within a set period of time.

•   Traveler’s Letter of Credit: With this kind of letter, travelers can make withdrawals in a foreign country because the issuing bank guarantees to honor any withdrawals.

•   Confirmed Letter of Credit: A seller using a confirmed letter of credit involves a secondary bank, typically the seller’s bank. This bank guarantees payment if the first bank fails to pay.

There is also an irrevocable letter of credit. This is a letter of credit that can’t be changed or canceled unless all parties agree.

Letter of Credit Example

Here’s an example of a letter of credit: A bank provides commercial letters of credit and stand-by letters of credit within two weeks. The funds are secured through deposits at the bank, and the terms are renewable. These documents can help reassure parties doing business internationally with new businesses or clients who have recently started a business.

The Money Behind a Letter of Credit

So where do the payment funds for a letter of credit originate? The party paying for the goods or services typically deposits funds in advance to the bank that issues the letter of credit to cover the payment. Alternatively, the amount might be frozen in the payer’s account or the payer might borrow from the bank using a line of credit.

When Does Payment Happen?

Payment usually occurs when the seller has completed all the stipulations in the letter of credit. For example, the seller might have to deliver the goods to a specific address or onto a ship for transportation in the case of international trade. In the latter case, shipping documents would serve as proof that the requirements for payment have been fulfilled. They might then trigger the payment transaction.

What to Watch Out for

Here are some common mistakes sellers may make when relying on a letter of credit for payment.

•   Failing to check all of the requirements in the letter of credit.

•   Failing to understand the documents required for the deal.

•   Failing to confirm whether the time limits for delivery and payment are reasonable.

•   Failing to meet the time limits.

•   Failing to get the necessary proof of delivery documents to the bank.

Letters of Credit Terminology

Here are some terms and phrases to know if you may be using letters of credit.

•   Advising bank: This is the bank that informs the seller that the letter of credit has been completed. The advising bank is also called the notifying bank.

•   Applicant: The party or buyer of products or services who applies for the letter of credit from the bank.

•   Beneficiary: The party, or seller, who will receive payment. The seller usually requests a letter of credit to guarantee payment.

•   Confirming bank: The bank that guarantees the payment of the required funds to the seller. If a third party is involved, the confirming bank is often the seller’s bank.

•   Freight forwarder: A shipping company that provides the transportation documents to the seller.

•   Intermediary: These are companies that link buyers and sellers and may use letters of credit to ensure transactions are executed.

•   Issuing bank: The bank that issues the letter of credit.

•   Negotiating bank: If a third party is involved, the negotiating bank works with the beneficiary and the other banks involved. They likely determine the letter of credit requirements to complete the transaction.

•   Shipper: The transportation company that ships goods.

•   Stand-by letter of credit: A secondary letter of credit that’s used when a deal requirement has not been met. For example, if payment does not occur within the specified timeframe, a stand-by letter of credit would then be used to help guarantee that the deal goes through.

Pros and Cons of Letters of Credit

A letter of credit provides security for both parties involved in a trade, but it can also add costs and time to business transactions.

How to Get a Letter of Credit

Getting a letter of credit usually requires a few steps. It’s wise to get the necessary paperwork together first. Various documents will usually be listed as requirements for a trade, such as a shipping bill, a commercial invoice, insurance documents, a certificate of origin, and a certificate of inspection.

Here are the steps typically taken to obtain a letter of credit.

1.    The buyer and seller come to agreement on the sale terms and the use of a letter of credit.

2.    The buyer contacts their bank where they have a checking account and requests a letter of credit and provides necessary documents.

3.    The issuing bank prepares the letter based on the terms of the sales agreement and sends it to the confirming bank or advising bank, which is typically in the seller’s home country.

4.    The confirming bank verifies the terms and forwards the letter to the seller.

5.    The goods can then be shipped, and the exporter sends documentation to the advising or confirming bank.

6.    Document verification and settlement of payment can then occur.

When to Use a Letter of Credit

A letter of credit is beneficial for sellers entering into a new trade relationship or an international trade relationship. It can provide assurance that the seller will receive payment because the issuing bank guarantees payment once the requirements have been met. Sellers may also use the guarantee of payment to borrow capital to fulfill the buyer’s order.

The Takeaway

A letter of credit is usually requested by an exporter or seller to minimize credit risk. The buyer of the goods or services applies to a bank and requests a letter of credit based on the sales agreement. This document helps guarantee that payment will be made. It can provide priceless peace of mind when conducting international trade or doing business with a new customer.

Another path to financial peace of mind: Choosing the right bank account. Whether you’re looking for a business account or a personal account, it’s wise to shop around to find the best banking fit for your needs.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

FAQ

How much does a letter of credit cost?

A typical fee for a letter of credit is typically 0.75% percent to 1.5% of the amount of the deal, but the rate will vary depending on the country and other factors.

How do you apply for a letter of credit?

Once the terms of a trade are agreed upon between the buyer and the seller, a buyer contacts their bank to request a letter of credit. They then gather the required documentation and fill out an application with that bank.

Why do you need a letter of credit?

The parties involved in a trade typically use a letter of credit to minimize risk. For the seller, a letter of credit can guarantee payment for goods once certain requirements have been met and the buyer confirms their creditworthiness as a trade partner.

Photo credit: iStock/Lesia_G

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