Contract Bonds (Performance Bonds)
A contract bond, also known as a performance bond, is a surety bond that is a project-specific guarantee between a contractor and their hiring party, known as an obligee. Construction jobs may require the contractor to secure a contract bond prior to starting work to guarantee they will perform work according to their contractual obligations.
If the contractor does not abide by the contract, the bond’s obligee (city, county, school district, or general contractor) can file a claim on the surety bond to potentially be reimbursed for up to the full bond limit.
Contract Bond Requirements
Federal, state, and local governments will require a contract bond depending on the project size. Per the 1935 Miller Act, any construction project awarded by the Federal Government and valued at $150,000 or greater requires a performance (contract) bond. Many states have adopted similar requirements. Businesses in the private sector have also made contract bonds mandatory for certain jobs to ensure their protection from financial losses due to the contractor.
Insurance companies offering the contract bond, known as the surety company, underwrite based on a contractor’s ability to complete the awarded project. Upon a review of various criteria, including prior completed works and financial capacity, the surety company will determine if the contractor is qualified to secure a contract bond, thus getting on the job. The contract bond mitigates risk for the obligee.
What Is the Cost of a Contract Bond?
The cost of contract bonds varies based on the contract amount, scaling down in percent as the contract amount get larger. Large contract amounts have a volume discount, the 25/15/10 rate, applied to the contract bond cost, as they can get costly. For example, a contract that is larger than $400,000 would be 2.5% of the first $100,000, 1.5% of the next $300,000, and 1.0% for the rest of the contract amount. See the chart below for examples:
| Contract Bonds | ||
|---|---|---|
| Contract Amount | Premium Percentage | Cost |
| Contract Amount: $100,000 | Premium Percentage: 3.0% | Cost: $3,000 |
| Contract Amount: $200,000 | Premium Percentage: 3.0 / 2.5% | Cost: $5,500 |
| Contract Amount: $1,000,000 | Premium Percentage: 2.5 / 1.5 / 1.0% | Cost: $13,000 |
| Contract Amount: $2,500,000 | Premium Percentage: 2.5 / 1.5 / 1.0% | Cost: $28,000 |
Rates can be higher or lower based on multiple factors such as financial stability, experience, project details, and reputation of the contractor.
How do I get Approved for a Contract Bond?
There are multiple phases of contract bonds, starting with getting approved for the contractors first bond. For a contractor attempting to obtain their first contract bond, finding a surety company willing to write a bond is the toughest step. With continuous and positive results, a contractor’s ability to get larger bond amounts and jobs will grow.
For jobs under approximately $500,000, the contractor will need to supply information proving they can complete the job as described in the contract. A soft inquiry of the contractor’s personal credit, financial strength and prior works completed are factors reviewed to qualify for this smaller contract bond.
Surety companies are looking for a high credit score, no amount past due, zero bankruptcies, etc. If there is negative credit activity on the report, the contractor may still be able to qualify for a surety bond with help from the Small Business Administration (SBA) by providing collateral. Jet does not provide these alternatives to the traditional contract bond.
The contract itself between the hiring party and the contractor factors into approval for a contract bond. Surety underwriters will review the contract, type of work performed and maintenance periods before approving a bond.
I Got Approved for a Contract Bond, Now What?
To be considered for some state and federal projects, a contractor has to be placed on an approved vendor list. Additionally, general contractors can require subcontractors to prove they can complete the contract. A letter of bondability is used in these instances to demonstrate the contractor’s bonding capacity and potential bond rate. The letter of bondability is provided at no cost by the surety company, so the contractor can be eligible for the vendor list or to work for a general contractor.
When a job becomes available, there will be a bid process to win the work. While in the bidding process, a bid bond may be needed. The bid bond guarantees if the contractor bidding on the project is awarded the contract, they will then enter into a contract with the obligee and post a performance and payment bond, if required.
Once awarded the contract, the contractor will be required to obtain a performance bond to guarantee the performance, per the contract. The contractor needs to submit the job specifications to the surety company, receive approval, and purchase the bond. A payment bond may also be required, which guarantees all labor and materials will be paid for.
Upon wrapping up the project, the obligee issues a General Status Inquiry, which is a notice of completion for the contractor to provide to the surety company. This notice allows the surety company to release the project amount back into the total available bond limit.
Getting Approved For Larger Projects
With the successful completion of smaller projects, a contractor can move onto bigger projects. Yet, a process still remains to qualify for a larger bond amount.
A soft credit check is still required for these larger contracts, but there are additional items required from the contractor as well to ensure they are qualified. These include: business financial statements, each owner’s personal financial statement, bank references, work in progress schedule, and an accounts receivable aging schedule.
What Happens If a Claim Is Filed Against the Bond?
Claims should be avoided at all costs, and as long as the contractor follows the contract, that shouldn’t be a problem. However, a claim may be filed on the contract bond if, for example, the completion of the project is pushed back or the contractor abandons the project.
Every claim that is brought up against a contract bond must be investigated by the surety company. If the claim is proved valid, the surety will pay out on the bond, but it is the contractor’s responsibility to pay back the surety for the full amount paid out in addition to legal fees.
Other Contract Bond Types
Maintenance Bond - A separate bond sometimes required on public projects which is coverage for defects and faults for a specified amount of time after project completion. Typically these coverages are included as part of the original contract.
Supply Bond - To guarantee the delivery of materials from the supplier. Contractors should not typically be asked to provide this bond since it relates to the supplier directly.
Subdivision Bond/Site Improvement Bond - Similar to a performance bond, this ensures public works improvements will be made by the developer and expectations will be met.