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What is a Construction Bond? Everything You Need to Know

8-minute read

A construction bond can help you land more work, like this construction manager and his employee.
Stephanie Clarke

Stephanie Clarke

24 September 2018

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Construction bonds are necessary when contractors and other repairmen, handymen or contractors are doing work in homes or other businesses.

The bond is called a surety bond, which means that it is really a contract between the person who is having work done, the person doing the work, and the company who is making sure that the work gets done.

If the work doesn’t get done, or if there is a problem with the work that is done, the company that issues the bond will pay damages to the customer, and then ask the person who took out the bond for reimbursement.

For many people in construction, home repair, and home improvement, construction bonds are vital for them to conduct business. Keep reading below to find out about the bonds, why they are needed, and how to apply for one.

Breaking Down Construction Bonds

Construction bonds represent a kind of surety bond that investors use in construction projects, especially large residential projects that require multiple contractors. The construction bond protects both the contractor’s business and the homeowner against disruptions in the event the contractor does not meet the client’s specifications or the company suffers a financial loss due to contract completion failures.

Why Do Contractors Need a Construction Bond?

Contractors, especially those who build large homes, do large remodels, or who go after business contracts are usually required by state or local regulations to put up a construction bond. This acts as an assurance to the owner of the project that the contractor will fulfill the terms of the agreement and complete the project.

Larger projects usually require two parts to the construction bond: first, that the job will be completed and second, that the materials ordered by subcontractors and labor performed will have been paid for, because no one will want liens on their homes or businesses -- as liens prevent owners from selling the property until the lien is satisfied.

In general, there are three parties that are involved with a construction bond. First, there are the property owner or owners who asked for the project. Second, there are the contractor and subcontractors who are responsible for making sure the project is completed. Third, there is the company (usually called a surety company) that backs the bond.

Depending on the size of the project, the project owner or investor could be a government agency or a company, as well as a homeowner for smaller projects. If the agency is a government agency, they first list the jobs that they want done, and then contractors who want to bid on a project within a government agency will put up a bond.

For large projects such as construction of a government building, for example, the bond required by the government states that they are able to complete the job in the time allowed under the contract. The contractor is also stating that he has the financial resources to hire subcontractors and buy materials to complete the project. In fact, when a contractor asks for a surety bond, he or she is stating they are in agreement to undergo background and financial checks before the surety company approves a bond.

Types of Construction Bonds

In a way, surety bonds act like an insurance policy for the agency or owner of the project that the project will be completed within the time allotted, with the approved construction, and with the materials agreed to by the client and the contractor.

Contractors are charged for construction bonds based on the financial health of the contractor, as well as the contractor’s record of finishing past jobs. Surety bonds help both the contractor and the agency, company owner, or homeowner who will need a project done. If a contractor has a sudden cash flow problems or he or she abandons a project altogether, construction bonds can replace the contractor or help the contractor with cash flow.

There are three types of bonds that are related to construction:

  • Bid bonds.

    Bid bonds are essential for contractors who are bidding on large projects, because in reality, contractors who want to do large projects can’t do them without a bid bond. Bid bonds are a guarantee that the contractor has the financial and employee resources to complete the project. To get a bid bond, the company issuing the bonds has to have done financial and background checks on the contractor to ensure he or she can handle the workload. For most government projects and large residential projects, a bid bond is necessary for competitive bidding.

    If the contractor backs out of the project, or does not move on to the next step, which is a performance bid, the company that guaranteed the bond will find another contractor to complete the project.

  • Performance bonds.

    Performance bonds are the second step in the bond process. Once a contractor accepts a bid and agrees to work on a project, the performance bond is put in place. Performance bonds work to protect the client or agency if the contractor does not follow through on the project. For example, if the contractor fails to finish the project, the bond company would hire another contractor to complete it. If the contractor does shoddy work on the project, uses defective parts or materials, or does not live up to his or her part of the contract, the bond ensures that the work is done to complete the terms of the contract.

  • Payment bonds.

    Depending on both the size of the contract and the contractor, sometimes a payment bond will be asked for, especially if the contractor has had problems in the past with paying bills on time. Payment bonds protect suppliers from contractors who don’t pay for their materials on time from suppliers. In addition, there are payment bonds, which specify that subcontractors must be paid on time as well. Payment bonds protect the owner of the property from having either suppliers or subcontractors come after them for payment when the project is finished.

How a Bond is Paid Off

So, if you are the project owner, and your contractor walks away from a project, what do you do? You make a claim against the construction bond for your financial losses because the project didn’t get done. You can also make a claim if work must be repaired because the original work was damaged or defective. Even if the contractor defaults on the job or the bond and declares bankruptcy, the bond company still owes you for the financial loss.

The bigger the project, the bigger the bond has to be to protect the owner if something goes wrong, and the bigger the project, the more likely something might go wrong. This is why nearly all government, public works, and large residential construction projects require a bond.

How Do You Get A Construction Bond?

First, if you need a bond for a bid you are working on, you need to know exactly which kind of bond you need. For the most part, if you are beginning the process of bidding on a large project, you will need to get a bid bond. However, you need to know exactly what kind of bond you are looking for, which means you need to contact the agency or company that wants the project done to see exactly what they are requiring. This is especially important if you are working in a state you are not familiar with, or if you are working in another country for the first time.

You need to get ahold of the company or agency and ask exactly what they require. For example, a small construction project of a new store in a small town which will have a smaller footprint than a house may require a different type of bond than a large apartment complex. Get the information you need to get started.

Second, you will need to begin the bond application process. If you have friends who are also in the construction business, you may want to ask them who they use for their bonds. You can also search online for a bonding company within your state or area. However, these days, many contractors look for companies that insure contractors nationwide, because a relationship with a national bonding company will allow you to work anywhere in the United States you want. Don’t be afraid to shop around for bond prices, because prices can vary wildly from state to state.

When you contact a surety bond company, you will be asked questions about your work experience and financial history, both within the contracting company and personally. You may have to undergo a business and a personal credit check as well. If your company has more than one owner, all the owners financials will be on the table for the surety company to look at. Well a less than stellar credit history won’t necessarily get you barred from obtaining a bond, especially if you have a history of performing well for clients and finishing projects, it might result in you paying a higher premium for the bond.

Third, you will need to shop around for quotes on your surety bond, because depending on the size of the project, they won’t be cheap. The price you may end up paying will depend on the amount of money you will need to have guaranteed. For example, if you are asking for a $15,000 surety bond for a project, it will cost you a lot less money than a $150,000 surety construction bond or a $1,500,000 surety bond.

After you tell your possible provider of the construction bond what you need, they will then calculate a premium -- which is based on your business and personal credit history. If you and your company have good credit the bond company will want you to pay between one and five percent of the total bond as a premium. This ‘good’ number can fluctuate depending on how much business you’ve done with the company and whether you have completed earlier projects on time.

If you have fair credit, this is your first time to seek a construction bond, or this is your first time working with this company, you may pay as much as 10% of the total construction bond as a premium. If you have poor credit, you may be required to pay as much as 20% of the bond amount as a premium. Don’t forget to shop around for a quote, because the amount needed from each surety company may vary.

Once you approve the quote, you will then have to pay the premium. If you have never done business with this company before, or you have less than stellar credit, you should expect to pay your full premium up front --construction bonds aren’t like an insurance company payment where they give you options for payment monthly, quarterly or yearly. Some large construction bond companies do offer financing to their premium customers with good credit, but in general, premiums are expected up front before the bond can be executed.

When you receive your bond, you need to check and make sure that all of the information is complete and it is accurate before you file it with the agency or business owner. If your business name isn’t correct, the address of your business is wrong, your bond will be rejected, and you will have to get a new bond. The bond amount must be correct also, and must be signed by all the parties involved with the bond. If there is an error on the bond, get it touch with the company to have it redone.

If all the information on the bond is correct, you can then file the bond with the agency or company that has requested the bond, and your part is finished.

Going through the bonding process may be a little tricky at first, but once you have done it a couple of times, you will be an expert. Remember, shop around for the best price, make sure you know what kind of bond is needed up front, and make sure your business and personal credit is as clean as possible, so you can get the best price.

Then, you can get to building!

Once bonded, don't forget to run a contractors insurance quote to ensure you're covered.

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