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PROTECT YOUR BUSINESS

What is a Construction Bond? Everything You Need to Know

7-minute read

Stephanie Clarke

Stephanie Clarke

26 August 2020

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

But they can also be complicated to apply for, especially if you're just starting out in the business.

That's where we're here to help. Keep reading below to find out what is a construction bond, why they are needed, and how to apply for one.

What Is a Construction Bond?

A construction bond (also known as a surety bond) is a contract between the person who is having work done (your customer), the person doing the work (that's you), and the company who is making sure that the work gets done (the bond issuer).

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.

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:

  • That the job will be completed
  • That the materials ordered by subcontractors and labor performed will have been paid for

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 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.

3 Types of Construction Bonds

1. 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.

2. 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.

3. 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.

Do I Need Business Insurance to Get a Construction Bond?

Before you start shopping around for a construction bond, take note: you'll likely need to show proof of business insurance.

This is because business insurance (including general liability and workers compensation) acts as another layer of security for your project work, as it financially protects you against claims involving:

  • Property damage
  • Accidents and injuries to third-parties
  • Reputational harm (slander/libel)
  • Employee injuries
  • And more

For example, let's say an employee of yours is smoking a cigarette during his break. When he's done, he tosses the cigarette and walks away. Unfortunately, the cigarette catches fire, causing an immense amount of property damage on the job site.

Even though you didn't cause the damage yourself, your business is still liable for the damages, as your employee was working for you

In this scenario, your general liability insurance policy could cover property damage costs associated with that accident.

Additionally, if your client decides to sue you, your policy could cover some or all of the costs involved with hiring a lawyer to defend you in court.

Construction bond companies are more likely to approve contractors who carry business insurance, so it's worth taking out a policy if you don't have one already. At Simply Business, we can design contractors insurance coverage for you that includes general liability insurance, contents coverage, and more!

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How to Apply for a Construction Bond

1. Find a bid bond company that specializes in your project.

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.

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.

2. Expect a financial background check.

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.

While 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.

3. Look through your construction bond quotes.

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.

What Happens Once You've Approved for a Construction Bond?

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.

The Construction Bond: Your First Step to a New Project

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!

This content is for general, informational purposes only and is not intended to provide legal, tax, accounting, or financial advice. Please obtain expert advice from industry specific professionals who may better understand your business’s needs. Read our full disclaimer

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