What are construction bonds?Construction bonds are like an insurance policy for your project. Depending on the types of bonds that are provided, they can help ensure that the work is completed, for the agreed upon price, and that everyone who works or provides materials for the project gets paid. They provide additional protection that contract language cannot, helping to protect the project owner financially.
There are three parties to most construction bonds: the obligee, the principal, and the surety company. The obligee on the bond is the party that is protected by the bond, or who funds would go to if a claim had to be filed. For most bonds, this will be the project owner (or it could be the general contractor who requires bonds on his/her subcontractors). The principal is the entity that purchases the bond, usually the general contractor or a subcontractor. The surety company is the company that provides the coverage and will investigate and pay out any claims.
Bonds are required on most public projects, both federal and state. Some states have certain contract limits at which bonding becomes necessary. Those limits, at the state and federal level, are set by law or statute. However, state or federal government departments can choose to require bonds if they want to, not just when required by law. On a privately funded project, it is up to the project owner if they want to require bonds or not. The cost for these bonds is usually passed on to the owner through a higher contract amount.
Types of construction bonds
Bid bondsBid bonds are issued for each bidding contractor at the time of the bid. They serve as a financial guarantee that the contractor will sign a contract for their submitted bid amount. This guarantee applies even if the contractor missed a portion of the work or made a mistake in their math. The bond protects the owner and ensures that they will not have to pay an additional amount in order to go to contract. These bonds don’t cost much, so there usually isn’t any financial impact to the owner.
If the successful bidder won’t sign a contract for the bid amount, then the owner can file a claim with the surety company. After it investigates the circumstances surrounding the claim, the guarantor may reimburse the owner for any additional expense required to go to contract with the next successful bidder. This type of bond is generally reserved for public projects that are subject to public bidding laws.
Payment bondsPayment bonds offer protection from mechanics liens or other collection claims. They help ensure that all parties that work on or provide materials for a project are paid. Each bond covers the contractors and suppliers that the principal pays and has a direct contractual relationship with. To ensure complete coverage for all parties on the project, the general contractor and each subcontractor need to provide these bonds. Payment bonds cost about 1/2 to 2% of the contract amount.
If the GC or a subcontractor fails to pay one of their vendors, and the project is covered by payment bonds, then the vendor who has not been paid can make a claim on the payment bond of their customer. They notify the surety company that there is an issue, the company investigates it, and makes a payment to the vendor if the claim is deemed valid. The owner won’t owe any additional costs for this payment. However, usually the principal will have to pay the guarantor back for any money paid out on their behalf as they have guaranteed the bond.
Performance bondsPerformance bonds ensure that the work covered by the contract will be completed. These bonds protect the owner from a failure to complete part of the work. Like payment bonds, each level of contractor provides a bond to support their work. These bonds cost about 1/2 to 2% of the contract price.
In this case, if the GC is having trouble with a subcontractor not performing, they can file a claim against the subcontractor’s performance bond. Then the surety company will either help the subcontractor finish the work, help the GC find someone else to finish the work, or take over that portion of the project and find a contractor to finish it. In all these situations, the GC and owner pay no additional money, even if the costs to finish the work go over the original contract amount.
Maintenance bondsMaintenance bonds are guarantees that improvements will be maintained and kept in good repair for a certain length of time. Jurisdictions often require these bonds to cover infrastructure improvements and large utility projects or connections. Once the maintenance period has elapsed, the bond is returned to the owner or contractor.
Why you should require bonds
Requiring bonds protects owners from companies that may walk off the project, go out of business or not have enough funding to complete it. When a general contractor or subcontractor applies for a bond from a surety company, they complete some background checking and financial research to make sure that the company is a good risk. They will look at the company’s financial records, past work, and current workload to ensure that they can meet the needs of the project. This screening process gives owners confidence in the contractors they have selected.
Bonds also offer protection against paying additional costs for work not completed or bills that haven’t been paid. Although the cost of the bonds is usually passed on to the owner, an additional 1 – 3% may be worth the peace of mind in knowing that the work will be completed, and everyone will be paid.
Most construction contracts have language in them to cover events such as not completing the work, or someone not being paid. However, they don’t provide guidance on who pays for the additional costs incurred when these types of events occur. Bonds provide further financial protection to the owner, ensuring them that there will be no additional costs even if there are issues on the project.
The bond application process, and cost, can serve as a deterrent against contractors who might not finish a job or might not pay all their vendors. If a contractor knows that they will be checked out thoroughly by the surety company, they may stay away from a bonded project. Also, the company won’t issue bonds if they feel they might be at risk.
Overall, bonds provide a layer of financial protection for the owner. They ensure that events like a subcontractor not completing work or a supplier not getting paid won’t affect them financially. There is an additional cost when asking for bonds on a project, but the protection gained is definitely worth it for certain projects and owners with little risk tolerance.