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Construction projects require a serious risk management in place that guarantees their timely and quality completion, as well as delivery of agreed payments to all relevant parties.
There are two common ways to manage risk in case of contractor default or when contractual agreements are not met: surety bond vs. letter of credit. While both offer sound financial protection, surety bonds have many advantages over letters of credit in terms of coverage, cost, duration and more. Most importantly, letters of credit do not guarantee the completion of the project, while surety bonds do.
What is a surety bond?
А surety bond is a third-party agreement among an obligee (the entity owning the construction project), a principal (the construction contractor) and the surety, which provides the bonding.
There are specific bonds that are used for construction projects:
- A performance bond acts as a guarantee that the contractor will perform all his obligations under the contractual agreement with the project owner.
- A payment bond (labor or material bond, for example) is a protection for subcontractors, workers and suppliers against contractor non-payment.
What is a letter of credit?
A letter of credit is also an agreement between three parties: a project owner, a construction contractor and a financial institution issuing the letter. It acts as a financial guarantee to the owner, who can call on the letter at any time, and as an interest-accumulating loan for the contractor.
The financial institution has no obligation to ensure the successful completion of the project. It focuses on financial compliance only.
Surety bond vs. letter of credit
There are major differences between a letter of credit and a surety bond in terms of costs, duration, project coverage, requirements and handling of claims. Let’s explore the comparison in depth.
| Letter of Credit | Surety Bond | |
|---|---|---|
| Costs and Period of Duration |
The letter of credit fees amount to 1% of the contract amount that the letter covers, which in turn is about 5-10% of the whole contract price, multiplied by the years of the contract. The bid price includes the letter of credit cost. The period of duration is usually one year, but may include automatic renewal, which is paid additionally. |
The surety bond cost varies for different projects, but is usually between 0.5% and 3% of the contract sum. In the case of construction projects, the bid price includes the bond cost as well. The bond covers the whole duration of the project, as well as a maintenance period that is agreed on top. |
| Project Coverage |
A letter of credit can be issued for any percentage of the project contract amount, but it’s usually between 5-10%. Subcontractors, workers and suppliers are not protected. |
Surety bonds cover 100% of the contract amount. The performance bond ensures full project completion, while the payment bond protects the subcontractors, workers and suppliers. There is an additional 10% maintenance coverage for defects for one year after the project is completed. |
| Requirements for Obtaining |
A financial institution investigates only the financial situation of the contractor. It checks whether the contractor can reimburse the costs in case the letter of credit is called on. If this factor is deemed satisfactory, there are no further checks. The contractor needs to secure liquid assets that decrease her line of credit and are seen as a liability. |
A surety bond provider examines the contractor’s business in its entirety before underwriting a bond. This includes its finances, management, workload and experience. The goal is to avoid default by judging in advance the ability of the contractor to finalize a project. The bond does not undermine the borrowing capacity of the contractor and might be even seen as boosting her credit reputation. |
| Handling Claims |
When the project owner requests the payment of the letter of credit within its period of coverage, the financial institution completes it. However, it does not provide support with the completion of the project, so the owner needs to tackle this, as well as claims by subcontractors, workers and suppliers. The letter of credit might not be enough to cover all costs. |
When a contractor defaults, the surety provider investigates the case. It can take a few courses of action:
|
Making the best choice in risk management
info_description[]="In the comparison surety bond vs. letter of credit, a surety bond obviously provides a much more complete risk management solution for construction projects. The costs and coverage are also more favorable. Obtaining the bond does not hurt contractors’ line of credit and thus contributes to their ability to complete a project."
Bryant Surety Bonds has a long history and rich experience in underwriting bonds for the construction industry. We would be happy to help you get bonded or to answer your questions regarding the bonding process. Contact us for more information, or choose the contract surety bond you need and apply today!
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