What is a contract bond?
A contract bond is a legal guarantee that the terms of a contract will be fulfilled.
They’re also known as construction bonds, as they’re typically used for building and renovation projects.
The purpose of a contract bond is to mitigate risk for the companies that commission these.
There are three parties involved in a contract bond.
- The obligee or owner of the bond i.e. the party selecting a contractor for the project.
- The contractor or principal, who’s responsible for carrying out the obligations outlined in the contract.
- A third party known as the surety(usually an insurance or bond company). They’re obligated to back the bond according to the contract’s terms.
What is the purpose of a contract bond?
The purpose of a contract bond is to reassure the obligee that the job will be completed according to the bid and contract terms.
This provides a financial safeguard and surety that the project will be carried out by either the original contractor or a replacement.
Under the Miller Act, prime contractors working on federal construction projects worth more than $100,0000 will require certain types of bonds.
Ergo, you may need a contract bond if you’re a contractor working for a federal agency.
Additionally, state and municipal governments might require contract bonds for construction projects.
Besides government contracts, many larger organizations require you to procure these to bid for a project.
Aside from providing financial protection, this works as a screening device, as only reputable contractors will be backed by a surety bond.
Types of contract bonds
Construction projects can be a major undertaking, so there are several types of contract bonds to assure project owners that these will be completed according to the contract’s terms.
The four main types are:
Bid bonds
This bond assures the obligee that the contractor will complete the project according to their initial bid.
It prevents them from bidding low and then changing the contract terms after winning the job.
A bid bond also protects the project owner should the winning contractor reject their bid. In this case, the surety company would pay the difference between the original bid and the next highest bid.
Performance bonds
These assure the obligee that the contractor will adhere to the contract’s terms and complete the project.
Should they fail to fulfill their obligation, the surety company is responsible for seeing the project through to completion.
Payment bonds
This type of bond applies when subcontractors, consultants, and suppliers are involved.
It assures these parties that they’ll be paid in full for any services and/or materials provided.
The surety company is responsible for handling any contract disputes involving pay.
Maintenance bonds
Also known as a warranty bond, these assure the project owner or developer that the completed project is built to last.
The terms will cover a defined period post-completion.
If the obligee discovers any faults or defects, the maintenance bond will cover the cost of resolving these.
There are also other types of construction bonds to mitigate risk in specific circumstances.
These include:
- Contractor license bonds
- Site improvement bonds
- Supply bonds
- Environmental compliance bonds
Contract bond vs. performance bond
So, what’s the difference between a contract bond and a performance bond?
Well, the former is an umbrella term for all types of construction bonds.
Each of these assures project completion and prevents financial disruption for the developer and/or subcontractors.
A performance bond, however, is a specific type of contract bond.
It guarantees the contractor will complete the job according to the contract’s specifications (e.g. in line with the contract effective date, timelines, and developer guidelines).
How do you get a contract bond?
The first requirement for a contract bond is proving your ability to fulfill your contractual obligations.
How you do this will depend on your company size, credit history, past projects, and the specific bond you’re seeking.
The steps to getting a contract bond are:
- Identifying which bond is required
- Finding a surety company
- Completing the application process
- Underwriting the bond
- Paying a premium
If you’re successful, you’ll then need to present the bond to the obligee.
How does a contract bond work?
A contract bond acts as a guarantee between three parties: the obligee (project owner), principal (contractor), and surety (bond company).
If the principal fulfills their contractual obligations, the bond won’t come into effect.
However, if the terms and conditions are not met, the surety company will be obligated to cover any financial losses.
Take a payment bond. During a project, the contractor subcontracts an electrician.
The contractor later goes bust and declares bankruptcy without paying them in full.
The electrician can claim against the bond. The surety company will be obligated to pay the outstanding amount.
What information is needed to qualify for a contract bond?
When you apply to a surety company for a contract bond, they’ll generally need the following information:
- Personal financial information
- Company financial statements and business assets
- A business history
- A list of employees
- Insurance coverage and current certificates
- A bank reference letter
In addition, the bond company will run a credit check on the owners and the business.
Some bonds require additional information, such as subcontractor or supplier details, too.
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