Payment and performance bonds provide financial protection in case a bonded party—like your construction business—fails to complete their contractual obligations. They ensure contractors follow the law and fulfill their responsibilities on public or private construction projects.
These bonds protect project owners, workers, suppliers, subcontractors, and other relevant parties in the construction process. They are also a type of surety bond or contract bond.
You’ll usually need both payment and performance bonds to work on public projects. Other types of bonds you might need include bid bonds, supply bonds, and maintenance bonds, which protect property owners as well.
Note: Payment and performance bonds differ from contractor license bonds because they only apply to specific projects. You need contractor license bonds to obtain your local or state license to work as a contractor.
How Payment and Performance Bonds Work
A surety company issues payment and performance bonds. They essentially back your construction business in exchange for a non-refundable bond premium.
The bond represents a contract between three parties:
- The principal—your construction company that needs the bonding
- The obligee—the entity that requires the bond, which is typically the project owner
- The surety—the company underwriting the bond
If you don’t fulfill your obligations under a construction contract, the obligee can file a claim against your bond to seek reimbursement or demand the satisfactory completion of a project.
The surety company will do an investigation—and if they find you at fault—they’ll step in to secure completion of the project or provide financial compensation. Afterwards the surety seeks full reimbursement from you, as set in the bond’s indemnity agreement.
When Do You Need Payment and Performance Bonds?
Payment and performance bonds are typically required to bid on public projects in order to help protect taxpayer money.
The Miller Act requires payment and performance bonds for federal construction projects above $100,000. There are also ‘Little Miller Acts’ on the state level, which define when you need bonds for state projects.
You may also need to get bonded for private projects. Homeowners and commercial bodies may ask you to secure these contract bonds as an extra protection mechanism.
Performance bonds guarantee the completion of construction projects according to the terms and conditions set in your contract. This type of bond works as a safety net in case of contractor default on a project.
More specifically, performance bonds ensure you will:
- Complete a project within the timeframe set in the contract
- Fully meet the quality requirements of the project
- Pay any losses to the project owner if you don’t fulfill your contractual obligations
The performance bond amount you’ll need to post depends on the project’s value. Typically, you’ll need a bond that’s between 50 to 100 percent of the contract sum.
Let’s say that you win a $500,000 public property project for constructing a city hall in Austin, Texas. The project owner, which is the City of Texas, requires you to post a performance bond equal to the contract amount. This means your bond must amount to $500,000 as well.
If you complete the building in due time and there are no issues with its quality, you’ve completed the contract. If, however, you delay the work, the City of Austin can seek financial reimbursement for losses caused by the delay.
Payment bonds guarantee full and timely payments to workers, material suppliers, and subcontractors.
The payment bond ensures you will:
- Pay suppliers and subcontractors on time
- Pay your employees on time and in compliance with state and federal laws
The Miller Act for federal projects includes first- and second-tier subcontractors, and suppliers and workers who work with a first-tier subcontractor. In the private industry, the terms of the payment bond are set on a case-by-case basis.
The payment bond amount depends on the contract value of the project you’ve won. It’s set individually for each project.
Let’s say you win a bid as a general contractor on a state road construction project. You’re going to work with suppliers who deliver materials and with subcontractors who take care of different parts of the projects. You also need to employ workers.
If you make timely payments to all of them, you’re sticking to the contract. If you fail to pay them on time, however, suppliers, subcontractors, or laborers may bring a claim against your payment bond. That’s how they can seek financial compensation—which the claimants can’t obtain from the project owner, but only from you as the prime contractor on the project.
How to Get Payment and Performance Bonds
You’ll need to apply to a surety company, which will examine your financial strength. It’ll take a close look at your personal and business finances to determine your bond premium.
The premium is a fraction of the bond amount required of you. Rates are typically between one and five percent. The exact percentage you’ll have to pay depends on your creditworthiness.
Usually you can’t get payment and performance bonds if you have bad credit. For larger bonds—above $250,000—the surety may also examine your business history, financial statements, and current active projects on top of your personal credit. The bonding company has to make sure you can compensate them for potential bond claims, which can be up to the full amount of your performance or payment bond.
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