Extra Edition / Business Management

A Look at Payment and Performance Bonds

construction siteDepending on one’s level of surety knowledge, some may call them payment bonds, another may say performance bonds, but insiders know they usually work collaboratively. Payment and performance bonds, which fall under the general umbrella of contractors bonds, are typically required on many major construction projects. In fact, most large-scale building projects cannot begin until the bonds are acquired and displayed.

Although they are often issued together, payment bonds and performance bonds differ in service.

History of Payment and Performance Bonds

Surety bonds became legally required on federal construction projects with the passing of the Miller Act. This act specifically applies to contracts exceeding $100,000, while the Federal Acquisition Regulation requires both performance and payment bonds on contracts higher than $150,000. Although the Miller Act only applies to federal construction projects, many state legislatures have enacted their own version of the law deeming them “Little Miller Acts.”

Performance bonds definition:

A performance bond guarantees the faithful performance of the contract. They are typically required by federal, state, and local governments in conjunction with work on public projects. Should the contractor fail to construct the buildings per specification, the client will be compensated for any monetary damages by the surety company issuing the bond.

Payment bonds definition:

A payment bond guarantees laborers (such as suppliers and subcontractors) are financially secure even in the event of a contract default. As with all surety bonds, should the contract be defaulted and laborers cannot be compensated, it is the surety company’s responsibility to reimburse them. The surety company will then seek damages from the bond purchaser, also known as the principal.

Surety Bond Cost

As with credit, bond premiums are not a set, standard number which can apply to all applicants. There are many factors which go into determining how much a surety bond costs. Many areas will be investigated such as the policies of the surety company issuing the bond, financial strength of the principal (the individual purchasing the bond), and the specific bond type required.

Even though there is not a set standard number which applies to all looking to purchase a surety bond, standard market rates are typically anywhere from 1 to 3 percent. Bad credit or high-risk applicants can pay anywhere from 5 to 20 percent of the bond amount.

In regards to payment and performance bonds, other items are also taken into consideration before supplying a bond. The specific industry or trade the surety bond is being written for is also examined, as well as the location where the bond is required. Surety bond requirements vary within regions; therefore rates may fluctuate depending upon how many bonds are needed in order to begin work on a project.

In general, for financially secure applicants who have a strong credit background, smaller contracts (those $1 million and under) may run between 1.5 and 2 percent of the contract amount. Keep in mind that typically bond costs decrease with the size of the bond; this means that extremely large performance bonds may even cost as little as less than 1 percent of the contract price.

Surety companies vary on how they choose to write their bonds, however. Some organizations choose to charge a flat fee (around 3 percent) of the contract price. Practices such as this are often used in instances when the parties aren’t as financially stable as other applicants.

Understand that contractor bonding requirements differ from state to state. The above serves as an overview to the services and cost for payment and performance bonds.

Publication date: 11/07/2011

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