A Quick Guide on Construction Bonds
In construction there are a lot of risks that can occur over the course of a project, both physical and financial in nature. As a result, measures such as insurance and bonding have been developed to help mitigate these risks and provide stakeholders the protection and peace of mind they need in order to get started.
As I mentioned before in my previous post about insurance (in case you missed it, check it out here), bonding is simply a means of protection for the owner against non-payment, poor performance, defaults, and warranty issues. There are actually several different types of construction bonds available, with new ones constantly being added as needs evolve.
In this article, we will focus on the most common types of bonding found in construction, breaking down who buys them, who can make claims, and how much they might cost.
What is a Construction Bond?
It is often beneficial to think of construction bonding in the same light as an insurance policy, with the main difference being that a bond contract is between 3 parties (obligee, principal, and surety), whereas insurance is just two. Insurance and Bonding differ in a couple of other aspects as well. For example, an insurance provider typically holds all the financial risk, whereas in bonding the risk is held by the applicant.
Typically, a contractor purchases a bond to either protect themselves and/or the project owner from potential issues during the course of a project. If a problem arises, the project owner (obligee) can file a claim against the principal, ultimately recovering the additional costs they incurred due to the default.
This is where things get a little different than insurance. Once a bond claim has been paid to an owner (obligee), the contractor (principal) must then pay back the surety for any money they paid out on the contractor's behalf.
When is Bonding Required?
Bonds are used in construction whenever the owner of a project requires additional protection. This is generally the case for most federal and public projects, and is becoming increasingly popular for smaller private projects as well. Basically, any project owner can ask contractors or suppliers to provide surety bonds. The costs for these bonds are then typically forwarded back to the owner by adding them to the original contract price.
3 Common Types of Construction Bonds
1. Bid Bonds - These bonds are designed to provide reassurance to a project owner that a contractor will follow through with their bid/quote, ultimately signing a contract for the quoted amount if they were awarded the job. This typically protects owners by preventing GC’s from backing out of a bid due to a variety of reasons such as inadvertently omitting something in their bid, or discovering that they made a mistake.
Cost: Some sureties don’t even charge for these bonds since their clients will often purchase a performance or payment bond as a result of winning the bid. Worst case, this should only cost you a couple hundred dollars.
2. Performance Bonds - A performance bond guarantees that a contractor will perform the work according to the scope of work outlined in the contract. These bonds protect owners from contractors defaulting during the course of construction. This is critical because having to pay someone else halfway through a project to come in and complete the work usually costs way more money. That is where a performance bond comes in. In the event that a contractor defaults and you have to bring in a replacement, all costs associated with the replacement are paid by the surety, and then forwarded to the defaulting party.
Cost: These bonds typically cost contractors anywhere from 1-3% of the total contract price.
3. Payment Bonds - Payment bonds guarantee that a contractor will pay their lower tier subcontractors, as well as protect the property owner from claims against the property title for non-payment. Typically these bonds are required on most public projects as they ensure that trades will get paid for the work they do. Under this bond, the GC is the principal, and suppliers and subcontractors are the obligees.
Cost: These bonds typically cost about 3% of the value of the contract, but vary greatly based on the credit history of the contractor.
Other Construction Bonds
Site Improvement Bonds
Labour and Material Bonds
Bad Credit Bond
Surety’s Consent of Agreement to Bond
How to Get a Bond?
If you’re looking to purchase a bond, the first thing you’ll need to do is search for a surety company. These companies are the bond providers and will be responsible for paying any claims that may arise. You may obtain a list of surety companies from your insurance agency or you can find one specializing in construction bonding yourself. Typically, if you work with an agency you’ll only have to fill out one application and they will do the shopping for you and provide you with a list of the best options for your situation.
Upon submitting your bond application, the next step will be the most detailed one. You will need to submit some additional information and documentation to go along with your application such as financial statements, work history, and project references. The sureties will use this information to assess your risk level in order to provide you with a proposal. That is when you make your selection and choose the surety that is best for you and your situation. That’s it, you’re bonded!
Manages Risks with Bonds
Simply put, construction bonds are a risk management tool for contractors and suppliers. They help protect stakeholders from financial harm, and provide reassurance that one bad egg won’t spoil the whole project for everyone. Ideally, and if used correctly, bonds provide benefits for all parties involved on a construction project and they are typically well worth the costs due to the magnitude of risks that they mitigate.
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