CONSTRUCTION KNOWLEDGE BLOG
December 16, 2011
I have a guest post blog today on a boring topic. Yet we should all understand the basics construction bonds, just to better understand our business.
When a project owner asks if you can bond the project, do you understand the question? Generally government projects require bonds (and occasionally private projects). The most commonly required surety bonds are payment and performance bonds. While they are two separate bonds that serve different purposes, they are usually acquired jointly.
Definition of Surety Bonds
Surety bonds are an agreement, or contract, between three parties. Each surety bond offers unique protections that, if not upheld, a claim can be filed upon the purchaser of the bond.
The parties involved in surety bond relationships are:
An obligee: the entity that is requiring the bond, typically a government organization
A surety: the agency providing the bond that ensures the principal will fulfill the work as specified by the bond
A principal: the business or person purchasing the bond
Background of Payment and Performance Bonds
The Miller Act, which requires bonds on federal construction projects with contracts exceeding $100,000, served as the foundation for surety bonds. Shortly following its passing several state legislatures adopted the act’s theory and deemed their requirements “Little Miller Acts.” Due to this, state bonding requirements vary from one area to another.
After the Miller Act’s passage, the Federal Acquisition Regulation was enacted which required payment bonds and performance bonds on contracts over $150,000.
Definition of Payment bonds
Payment bonds provide guarantees that all involved on a project will be fully compensated in the event the contract is voided or broken. Subcontractors, suppliers, laborers and materials are a few examples of those protected by payment bonds. Should a contractor default, those safeguarded by payment bonds will be compensated by the surety agency who wrote the payment bond. Following this, the surety will then seek retribution from the contracting organization who purchased the bond.
Definition of Performance bonds
Performance bonds, on the other hand, refer more to protecting the clauses within the contract. A performance bond is typically required from federal and state governments for work on public projects. The types of protections performance bonds ensure vary from one area to another, but typically refer to how a building is constructed, or the time in which the project should be completed by.
Surety Bond Cost
The most commonly asked questions regarding surety bonds are, often times, centered on their cost. Unfortunately, there is not one set cost of surety bonds, nor is there a set rate. Rather, surety bond rates work similarity to how credit rates are set for individuals. Several areas must first be researched before a final quote and price can be delivered to customers. These include: an individual’s financial history, the type of bond, and the surety’s policies.
Although rates can vary from one applicant to another, standard market rates are typically anywhere from 1 to 3 percent. Bad credit programs are available for high-risk applicants who have weaker financial backgrounds than others. These applicants typically pay higher rates between 5 to 20 percent of the bond amount.
In specific to payment and performance bonds, other items are investigated before supplying a bond. Surety agents will research the industry the surety bond is being written for, as well as where the bond is required. As surety bond requirements vary from state to state, rates can also fluctuate depending on how risky the project may appear and how many bonds are required in order to begin a project.
For financially stable applicants, typical costs (for contracts $1 million and under) can range between 1.5 and 2 percent of the contract amount. Also, bond costs decrease with the size of the bond. This means applicants may pay less than 1 percent of the contract price for performance and payment bonds on large-scale projects.