Industry Insights

Understanding the Importance of Construction Bonds: Ensuring Project Completion and Financial Protection

Kristen Frisa
January 17, 2024
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Construction bonds help to protect a project owner’s investment in case a contractor doesn’t finish the work according to the project contract. Bonds are agreements between the owner, the contractor, and a surety company that provides the bonds. 

Contract bonds are required for public works projects. However, owners in the private sphere often require contractors to obtain bonds, too. 

This article will discuss the different types of construction bonds and the ways they work within construction projects.

Why do construction projects need bonds?

Owners face considerable risk during the construction process: they pay contractors to do the work in good faith that they will complete the project correctly and on time. On large projects worth hundreds of thousands or millions of dollars, even the initial payments represent a significant investment in the finished product, and the property owner stands to lose a lot of money if the general contractor can’t finish the build for any reason.

The contract offers owners a certain level of protection – if a contractor doesn’t fulfill the agreed-upon terms, the owner can sue the contractor for breach of contract. However, lawsuits take time and themselves cost money, so the protection they offer is limited. Bonds offer increased protection to mitigate the risks to project owners.

Without the benefit of construction bonds, owners might be less willing to begin construction projects, which would be harmful to the owner, the contractor, and potentially to the construction industry as a whole.

How do construction bonds work?

Construction bonds are agreements between three separate parties: the principal (contractor), the obligee (owner), and the surety company that provides the bond.

The owner requires the contractor to obtain a surety bond before construction begins and sets expectations for the amount of the bond and the threshold requirements the contractor must meet to avoid the owner filing a surety claim.

The contractor pays the surety bond company a premium for issuing the bond, often a percentage of the total bonded amount. Whether or not the surety company will provide a contractor with a bond will depend on the contractor’s financial and professional track record, including the company’s credit score.

If, for any reason, the contractor does not complete the work according to the project contract, the owner can file a bond claim to the surety company. Once that claim is settled and the surety company pays out the bond to the owner, it will seek to get the money back from the contractor.

The types of construction bonds

The term “construction bond” actually refers to different construction bond types, each with its own uses and rules. In many cases, a single construction project will require the use of various types of bonds. The following are three of the most common types of contractor bonds.

Bid bond

Bid bonds assure a project owner that, should a contractor be awarded a tender, the contractor will proceed with the project as bid. If the contractor refuses to enter into a contract after winning the bid, the surety company will cover the price between the winning bid and the next lowest bid.

Performance bond

Performance bonds assure that a contractor who has agreed to a construction contract will complete the work as stipulated according to the requirements of the contract. The owner can make a claim on a performance bond if the contractor misses a completion deadline or doesn’t meet quality standards or some other metric of success on the project.

Payment bond

Payment bonds cover the cost of labor and materials on a construction project if a contractor has failed to pay those bills.

The benefits of construction bonds

Contract bonds help to mitigate risks and encourage activity within the construction industry. They protect property owners while offering further incentives for contractors to follow through with their work as contracted.

Financial protection for owners

The financial benefits of construction bonds for owners are straightforward. When a contractor takes out a construction bond, the owner is financially protected from a construction business who walks away from a partially finished job or can’t complete the job as contracted.

Other forms of financial security, like letters of credit or self-insurance, may not offer the same protection level as surety bonds.

Through bonds, owners can be completely compensated for the losses from the failed contractual agreement. This assurance minimizes the risk the owner takes when embarking on the project.

Construction businesses can do their part to ensure financial success by using a secure and reliable payment system like Truss. Truss offers a fast and simple solution to collect receivables from owners and provides bank-grade security to ensure payments reach contractors safely and quickly, preventing delays in the mail, NSF events, and fraud.

Guarantees project completion

In order to obtain a construction bond, a construction company must submit to rigorous vetting by a surety company, which will investigate the firm’s track record, credit score, and overall risk profile. Owners who require contractors to get a construction bond can feel confident that the firm is experienced and professional, and the contract bond guarantees the company is able to complete the construction project as contracted.

If the contractor fails to complete the project, the owner will be compensated and be able to seek another contractor to finish the work.

Benefits to the contractor

Construction bonds benefit contractors, too. The contractor covers the expense of taking out the bond and won’t receive any coverage from its existence. However, the benefit to the contractor comes from the assurances to the owner. By increasing the owner’s comfort level and managing the overall risks in the project, construction bonds can make a contractor seem like a safe bet and increase professional opportunities.

A subcontractor benefits from contract surety bonds because they won’t have to file a mechanics lien should they fail to receive payment from a general contractor. Instead, the bonding company will cover their fees.

To avoid surety bond claims, general contractors should ensure payments go out to subcontractors as soon as possible. With Truss, construction companies can send free ACH payments to subs online in minutes and give them instant access to funds.  

Potential risks and challenges with construction bonds

Surety bonds have many advantages within the construction landscape, but they come with some challenges for contractors, particularly during the bonding process.

Contractors may have difficulty obtaining a bond

Although many people think of a construction surety bond as a type of insurance, contractors may find that the process of qualifying for a bond is more like applying for credit at a financial institution. Surety companies look into contractors’ financials and work histories to establish their professional abilities to handle a new project.

Contractors face the risk that they will not pass the surety company requirements, which would significantly impact project opportunities. Contractors may have to spend significant time and effort establishing a relationship with a surety company.

Financial implications for contractors

Obtaining bonds isn’t free – a surety company charges premiums for securing the work. Depending on the size of the project and a contractor’s credit score, premiums can range anywhere from 1% to 15% of the total contract amount. The contractor must consider surety costs when bidding on project work.

If a claim is made against a contract surety bond, the bond company will pay the claim, paying up to the full amount of the bond, and then look to the contractor for compensation.

Construction surety bonds play an important role in construction

Construction bonds have been around for a long time, and for a good reason – limiting owners’ risks helps build a more robust and thriving construction industry. Surety companies help vet construction businesses to ensure they’re not taking on more complicated or expensive work than they can handle, and subcontractors have the means to recoup any missed payments for the work they’ve done.

Surety bonds aren’t without their downsides, though. They may be difficult or time-consuming for contractors, and files claimed against a surety bond may be costly to repay.

Contractors should carefully consider their financial and organizational capability to deliver a successful construction project before tendering a bid in order to reduce risks across construction stakeholders and keep projects moving successfully.

Making and receiving payments quickly and securely can go a long way to improving financial security throughout a construction project. Contractors can integrate Truss with their accounting software to collect payments faster and pay subcontractors and materials suppliers instantly through their Truss accounts to maintain a healthy cash flow.

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