There is often confusion between bonds and bank guarantees. We hope to help clear that confusion in this post. Here’s what you need to know about performance bonds vs bank guarantees.
What Are They?
Performance bonds are a type of surety bond commonly used in the construction industry to protect project owners from financial loss due to a contractor defaulting on a contract. As you can imagine, a contractor’s insolvency and failure to complete a large project can cost the project owner a great deal of money.
A performance bond can provide the funds needed to bring in another contractor or take whatever other measures are necessary to complete the project. Similar protection can be obtained through a bank guarantee.
When used as an alternative to a performance bond, a bank guarantee is typically in the form of a letter of credit issued to the project owner in an amount significantly less than the total cost of the project. The letter of credit is secured by assets the contractor pledges to the bank.
Who Needs Them?
Performance bonds are required under the Miller Act, in conjunction with a payment bond, for all federal public works projects valued at $100,000 or more. Individual states have passed similar “Little Miller Acts” for public works projects valued in excess of $50,000. Owners of large private construction projects often require performance bonds as well.
Again, a bank guarantee in the form of a letter of credit may be considered an acceptable alternative. Be sure to check with project owners if you decide to go this route, as the bond is the more commonly accepted option.
How Do They Work?
In the event of the contractor’s default, the project owner (the obligee in the surety bond agreement) may file a claim against the performance bond. The surety company will first ensure that the claim is valid and will then pay the claim. This may give the project owner the funds to finance the contractor’s remaining work on the project or pay another contractor to complete the project. Note, however, that the contractor is ultimately responsible for repaying any claim amounts. In some cases, the surety may choose to act as contractor and subcontract out the remainder of the work left to be done on the project.
The claims process works in much the same way when there is a bank’s letter of credit in place rather than a surety bond. The main difference is that a bank is more likely to simply pay the claim and collect the claim amount from the contractor. The bank, like a surety company, nearly always requires an indemnification clause that obligates the contractor to repay any funds paid out to the obligee on a claim.
What Do They Cost?
The premium paid by a contractor for a performance bond is a small percentage of the full penal amount of the bond, which is established by the obligee. For contractors with excellent credit and in good financial standing, that can be as little as 1% to 3% of the required bond amount. The premium is paid upfront as one lump sum.
The cost of a letter of credit typically fluctuates with the rise and fall of interest rates during the period that the letter of credit is in effect. There may be other, ongoing administrative fees in addition to the fee charged for issuing the letter of credit, and fees may be payable on a quarterly or semiannual basis. The other consideration with a letter of credit is that it will tie up assets pledged by the contractor, thus reducing the contractor’s borrowing capacity.
Get A Performance Bond Quote
Our experts will gladly answer any questions you may have about the relative advantages and disadvantages of performance bonds and bank guarantees. Or, if you’re ready, simply ask us for a performance bond quote to fulfill your next project.