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What are Construction Bonds and How Do they Work?


Jack Gordon - August 12, 2020 - 0 comments

The goal of every investor is to get a good return on their investment no matter the kind of investment it is. This is also true for construction jobs. In these kinds of projects, there is a possibility that builders do not for some reason finish the project, they carry out a shoddy job or maybe it was disrupted. To help cater to and protect the investor if any of these were to happen, there is what is called construction bonds.

What are Construction Bonds?

These can also be referred to as contractor bonds. They are a type of instrument used in construction that provides a financial guarantee that bills incurred on a project will be paid. This means that the insuring company or bank is giving the assurance that the project will be completed by a contractor. They protect the investor against any disruption or financial loss which may come about as a result of a builder failing to finish the project or meeting up to already agreed specifications.

Most construction contracts will usually have provisions for what should happen in the event that a builder fails to complete the project. However, there is usually no financial protection for the owner and this could lead to additional cost for the investor to complete it. By requesting a surety bond, the investor gets a financial cover in case they need to spend more to complete the job. This is especially true when using public funds.

How it Works

Construction bonds typically involve three parties:

  • The project owner or investor who is referred to as the obligee.
  • The contractor working on the project who is the principal.
  • The insurer or surety company.

The principal is the purchaser of the instrument. This can be a general contractor or a subcontractor. For most kinds of construction jobs, especially with government or any public entity, they are required to have one for any job that is more than $100,000. Also, private investors can request that a builder provide it for their project.

For large projects, these can come in two parts with one part acting as protection for the overall completion of a project and the other protecting against material suppliers and subcontractors that supply labor.

When an obligee lists a job, they require all contractors bidding for it to put up a bond in order to reduce the possibility of any financial loss. Submitting one shows that as a builder, they can complete the project based on the specified contract and quality required.

The principal buys the instrument from a surety and before it is approved, the surety runs an extensive background and financial check on the contractor. This makes both the surety and principal liable if the builder fails to finish the project or abide by already agreed terms. There are brokers like contractorbond.org that collaborate with surety companies to help contractors get low insurance rates.

Requirements

For businesses that use these instruments, the requirements to follow include:

  • Reviewing the project to see if one is needed.
  • If need be, the principal gets one from the surety and submits it with a bid.
  • If the contractor wins the bid, they approach the surety for a performance bond.
  • The principal completes the job.
  • If required, the principal gets a maintenance bond to carry out any repairs.

Types

There are three major types of these instruments that can be provided by a surety. They are:

Bid Bonds

This is a type that is necessary for a competitive bid process and protects the investor if the principal refuses to honor the bid after winning it. Each contractor submits one alongside their bids and the obligee has the right to sue the principal and the surety to enforce it if there is a need to get a replacement contractor. The surety and principal are liable to cover any additional costs.

Performance Bonds

These replace the bid bond after the principal accepts the bid and it is used to guarantee that the principal will complete the job. It primarily protects the obligee in a case where the project is not completed, is defective, or is not according to specifications.

Payment Bonds

These guarantees that the principal has the financial capacity to pay and compensate workers, material suppliers, and subcontractors. You can learn more about these here.

Conclusion

Getting a construction bond makes you trustworthy as a contractor and will give you an edge when you need to win contract bids. You should ensure you use brokers that are experts in getting you low rates from reputable insurers.

With the information you gotten in this article, you should now be more comfortable with how to go about getting these bonds.

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