The hidden costs of a payroll letter of credit

Many New Zealand payroll companies provide a full ‘bureau’ service, meaning they manage the process for you completely, including paying your staff.

In order to use these payroll bureau services, you’ll almost certainly be required to provide a letter of credit from your bank. It sounds straightforward enough, but there’s not much info out there explaining exactly what’s involved.

There’s a reason for that. Getting a payroll letter of credit is a bigger ask than they let on and you should really think about whether it's worth your while.

Let me explain.

Why do many payroll companies require a letter of credit?

Here’s how it works. On payday your payroll company will withdraw the full amount you need to pay your staff and IRD from your account and deposit it in their trust account.

They then need to pay the wages to each of your employees from that trust account (they hold on to the PAYE amount until it is due on the 20th of the following month).

The problem is that it takes a few days for the funds they withdrew from your account to clear. But they need to pay your staff on the same day, before they know for sure that the funds they have received from you won’t be reversed out.

If you don’t have the required funds available in your account and the transaction fails they will end up in the lurch.

Now, those payroll companies aren’t going to take that risk (they’re not stupid). So they insist that you provide a letter of credit from your bank.

What is a payroll letter of credit?

A letter of credit is essentially a guarantee that your bank will honour a payment to your payroll provider if the initial transaction fails because you didn’t have enough money in your account.

Your bank isn’t going to take that risk (they’re not stupid), so in most cases they require that you provide some sort of security.

When it comes to security, the requirements vary from bank to bank.

If the past performance of your business is very strong and you have a good long-term relationship with your bank, you might be lucky enough to arrange an extension of your credit (similar to an overdraft facility, but only your payroll provider can draw from it).

However, in most cases you’ll either need to provide a director’s personal guarantee (possibly using your private home as security), or even set up a separate account that contains the equivalent of at least one month of your payroll.

Here are the top four reasons why payroll letters of credit suck:

1. They can crush your cash flow

How much is your monthly payroll? That’s how much your bank could make you put aside in a separate account that you cannot access if you sign up to a letter of credit.

A company with 10 employees all earning $60,000 has an annual payroll bill of $600,000, or $50,000 a month. Having to put $50k into a term deposit you cannot access may be good for enforced savings, but it’s an absolute killer when it comes to your cash flow!

2. They limit your access to other borrowing

A letter of credit is just another form of lending and may reduce your access to an overdraft or similar credit facilities. If you’ve had to provide a personal guarantee, it could limit the amount you can borrow for a mortgage.

3. They’re expensive

Each bank is different, but to arrange your payroll letter of credit you’re looking at a set up fee of about $250 and an ongoing fee of about 1% p.a. Take the example above with a letter of credit for $50k and that 1% works out at $500 a year.

$750 is a heck of a lot of money to pay your bank for a letter of credit, and that’s before you even start paying your payroll provider.

4. They can take aaaaaages to sort out

To get a letter of credit signed and sorted takes a minimum of a few days and often several weeks. Banks don’t give letters of credit away lightly and will make you jump through a few hoops.

When you’ve decided you want to switch to a new payroll system the last thing you want to do is muck around waiting for your bank to get sorted. You’re going to want to jump right in and get started with a free trial of the payroll software.

How does PayHero do it differently?

We understand what it’s like to run a small business and can totally relate to the appeal of a fully managed payroll service where you can set and forget. However, when you’re required to provide a letter of credit for that service it just doesn’t stack up.

FlexiTime will never take money out of your bank account so we don’t require a payroll letter of credit. Instead, we make it easy for you to pay your employees and IRD yourself.

When you complete a pay, you can use Pay Now to transfer the funds to your employees and Inland Revenue via a POLi payment from inside PayHero.

Otherwise, PayHero automatically creates a bank file. All you have to do is log in to your business banking account, upload the bank file and check and confirm the payments. It literally takes two minutes and saves you a lot of hassle and expense.