By Victor Lance
For most contractors working in the U.S., construction bonds are one of the major requirements they need to meet in order to even apply for a project. Still, they are often confused by these bonds, and not without reason. Namely, construction bonds are tricky to define and even trickier to understand. That’s why in this article, we’ll do our best to present everything you need to know about construction bonds.
1. What Are Construction Bonds?
Construction bonds are a class of surety bonds used in the construction industry. The main purpose of these bonds is to make sure that a construction project is completed in accordance with all terms and conditions stated in the contract.
What is more, if a contracting company (aka the principal) fails to meet its contractual obligations, the construction bond holds it responsible for any financial losses that came as a result of this failure. In other words, if the project owner (aka the obligee) can prove that work wasn’t performed as agreed, they can use these bonds to access funding and hire another contractor.
2. How Do Construction Bonds Work?
As we’ve mentioned, if the outcome of a construction project doesn’t resemble the plan outlined in the contract, the obligee is entitled to file a bond claim. Afterward, the surety company that issued the bond has to conduct an investigation into that claim. If this investigation shows that the claim is valid, the surety can address the problem in two ways.
The faster and easier way to resolve the issue would be through the mediation of the surety. However, if mediation isn’t possible, the surety will swiftly make financial compensation to the obligee so that the project can continue without further interruptions. Still, the principal is ultimately the one that covers these losses since they need to repay the surety for the claim.
3. Different Types of Construction Bonds
The term construction bond refers to a whole class of surety bonds. Furthermore, this class encompasses several different types of bonds, each related to a different set of risks. Three main types of construction bonds provided by a surety are bid bonds, performance bonds, and payment bonds.
Bid Bond
This type of construction bond is used as a guarantee that the bonded contractor will not back out of the project if they win a bid. In addition, it can serve as an assurance that the contractor is able to meet the performance requirements outlined in the project plan. Bid bonds are usually only required for public projects, although private project owners could also make them mandatory.
Performance Bond
Performance bonds are required once a construction company signs a contract and starts working on a project. This bond guarantees that the contractor will be able to finish the project adequately, timely, and without going over a specified budget. In addition, if any of these conditions aren’t met, the project owner can use the bond to cover their financial losses.
Payment Bond
The main goal of this bond is to ensure that the construction firm compensates its subcontractors, laborers, and suppliers. So, unlike the previous two types of construction bonds, the payment bond does not protect the owner of the project. Still, some project owners require contractors to have this bond, as the success of the project largely depends on the third-party agents.
4. How Much do Construction Bonds Cost?
Surety bond cost depends on different factors, from the principal’s industry experience to their credit and financial strength. What’s more, different types of construction bonds will have different price tags, with bid bonds being the least expensive ones. Finally, the bond rate will vary based on the surety company and the size of the contract. Generally speaking, the cost of a construction bond can go anywhere from 1% to 4% of the total contract amount.
5. Are Construction Bonds Obligatory?
Although this question is fairly straightforward, the answer couldn’t be more complex. First of all, in the case of public projects, construction bonds will, more often than not, be required by the local or federal authorities. However, if a construction project is commercial, the project owner can choose whether the contractor should be bonded or not.
Another issue that makes the answer to this question even more complicated is the type of bond required for a specific project. Namely, project managers might demand a performance bond but not a payment bond or vice versa. Therefore, contractors need to check the project requirements closely before they submit their bids.
6. What Are the Benefits of Construction Bonds?
Even though getting a construction bond may seem like a waste of resources, these documents are far from worthless. In fact, they can benefit both the contractor and the project owner. And as a project owner, it’s easy to see why hiring a bonded contractor would be favorable. However, the advantages that construction bonds have for contractors aren’t as obvious. Still, they are far from nonexistent, and they include:
Easy Access to Public Projects
As we’ve mentioned, most public construction projects require a construction bond. Therefore, a contractor with a bond to their name will have no problem accessing any public bids. And seeing how valuable public projects can be, having a surety readily available can truly pay off.
Fewer Contract Disputes
When a contractor is neither insured nor bonded, it’s easy for a project owner to dispute one of the performance parameters covered by a contract. Furthermore, they will sometimes misuse disputes to withhold payments or get additional services. However, once the contractor has the surety behind them, they can be sure that those situations will occur less often. Namely, the surety will thoroughly investigate every contract dispute, which makes abuses impossible.
Better Employees and Partners
As we’ve previously explained, payment bonds guarantee that a contractor will compensate its subcontractors, suppliers, or laborers. Thus, a contractor with this bond is seen as both a stable partner and a desirable employer. Furthermore, project managers will always go for someone that has strong relations with their associates and workers, which is another advantage of payment bonds.
Signaling Stability and Reliability
Finally, having a construction bond as a contractor sends a strong signal to potential customers. Namely, it tells them that you are certain that you can do your job without any issues. On the other hand, an unbonded contractor appears both unstable and unreliable, even if they promise the same results.
Final Thoughts
As a contractor, you have to deal with piles of paperwork every single day, and the construction bonds aren’t making things easier. Hopefully, this article helped you understand more about these bonds and their role in the construction industry. So, whether you want to work on public projects or appear more reliable, contact a surety company such as Lance Surety Bonds today.
Victor Lance is the founder and president of Lance Surety Bond Associates, Inc. He began his career as an officer in the U.S. Marine Corps, serving two combat tours. As president of Lance Surety, he now focuses on educating and assisting small businesses throughout the country with various license and bond requirements. Victor graduated from Villanova University with a degree in Business Administration and holds a Masters in Business Administration (MBA) from the University of Michigan's Ross School of Business.