Surety bonds vs Letters of creditA surety bond and a letter of credit (LOC) are similar because both are used to guarantee performance under a contract. However, there are variances in the costs and benefits, which make surety bonds and LOCs different.

Choosing the correct form of risk management can make a huge difference in regards to limiting exposure employee’s face while working in dangerous industries such as construction.

Surety Bond

A surety bond is an agreement made among three-parties, the surety, the project owner (obligee), and the contractor (principal). If a contractor defaults, the performance bond helps protect the owner from nonperformance and financial liability.

A payment bond such as a labor bond and material bond helps protect specific subcontractors, laborers, and material suppliers should there be no payment made by a contractor.

  • Borrowing Capacity – Usually issued on an unsecured basis, performance and payment bonds are typically provided based on the company’s financial strength, experience, corporate and personal reimbursement. The bonds that are issued will not diminish the contractors borrowing capacity, but instead, may be seen as a credit enhancement.
  • Prequalification – A surety company such as IOA Bonds, looks at various factors to validate that the contractor is capable of completing the work set under their contract to avoid defaulting.
  • Duration – Surety bonds remain in effect for the length of the contract plus a maintenance period.
  • Cost – The bond is project specific for the length of the contract. The cost is included in the contractor’s bid price which is generally 0.5% – 3% of the contract price.
  • Coverage – At least 10% coverage for maintenance of defects the first year after completion.

Letter of Credit

Obtained through a banking or lending institution, a LOC is a cash agreement to the owner, who can call on the LOC as needed. The LOC turns to a payment for the owner and to a loan on which interest is paid by the contractor. The performance of the contract has no significance on the bank’s responsibility to pay on the LOC.

  • Borrowing Capacity – Bank LOCs cause the contractors line of credit to lessen and show on a contractor’s financial statement as a contingent liability.
  • Prequalification – The bank will check the collateral’s quality and liquidity to ensure the contractor will be able to reimburse the bank if a demand is made upon the LOC. If so, no further prequalification is required.
  • Duration – Surety bonds remain in effect for the length of the contract plus a maintenance period.
  • Cost – The bond is project specific for the length of the contract. The cost is included in the contractor’s bid price which is generally 0.5% – 3% of the contract price.
  • Coverage – At least 10% coverage for maintenance of defects the first year after completion.

Both the surety bond and letter of credit are underwritten and priced based on the credit strength of the indemnitor. Sometimes the fees for a LOC seem to cost less than a surety bond’s premiums. However, the LOC restricts the use of your liquid capital, causing you to pay more.

Unlike a LOC that can be drawn upon by merely presenting a demand to the bank, a surety bond permits a detailed investigation into whether a claim on a bond is valid or not.

If you need help deciding whether a surety bond or a letter of credit would work better to help protect your business, then contact the professionals at IOA Bonds today by calling 1-866-379-3151 or by completing the contact us for a quote form online.