What Is a Performance Bond — and How Much Do They Cost?
If you've ever worked in construction or on a real estate development project, chances are you've heard the term "performance bond" before. If you haven't, the lingo might be completely new. Regardless of your familiarity with the term, you might still be wondering what performance bonds are, exactly.
Here, we'll delve into what performance bonds do, how they compare to insurance, and more. In short, it's time for Performance Bonds 101.
So, What Is a Performance Bond and How Much Do They Cost?
A performance bond, also sometimes called a contract bond, is a sort of guarantee that's issued to one party involved in a contract by the other involved party. In essence, it states that not only does the issuing party intend to uphold their end of the bargain, but that they are willing to back up their promise to do so financially.
Performance bonds are a type of surety bond, which means that a third party comes into play in order to oversee the contract between the two signing parties. Usually, this third party is a financial institution, such as a bank or insurance company, which assumes the payout responsibilities if a claim is issued.
Performance Bond Basics
Performance bonds are commonly used in contracts for large projects, such as those involving construction or real estate development. It's a safe bet that if a project uses general contractors for its operations, a performance bond will be in play.
If the job goes through a bidding process, payment and performance bonds are usually set up with the winning bidder in order to cement the agreement, so to speak. Additionally, performance bonds are always used on any public work project with a budget of $100,000 or more. This is not just good practice but required by a law called The Miller Act.
How Performance Bonds Work
Let's use an example to better illustrate how a performance bond actually works and what role everyone involved plays. Say that a city, Exampleville, wanted its roads repaved by a contractor, Roads R' Us. Roads R' Us agrees to take on the project and is willing to guarantee their work with a performance bond.
In order to get a performance bond on the agreement, the two parties go to an insurance company called ABC Insurance. There are now three parties involved:
- The Principal: The company doing the work — in this case, Roads R' Us.
- The Obligee: The customer or party that's paying for the service or goods, which, here, would be Exampleville.
- The Surety: The third-party financial institution providing the performance bond. In this instance, that would be ABC Insurance.
Under the terms of the performance bond, if Roads R' Us failed to complete the project — or if their job wasn't up to the specified conditions — then the town of Exampleville would file a claim against the bond. ABC Insurance would pay the bond's amount to Exampleville and then ask Roads R' Us to repay them.
Types of Performance Bonds
While there aren't really different types of performance bonds, they can be used in a variety of ways. As we mentioned above, performance bonds are commonly used as a sort of guarantee that a large project will be completed as outlined in a contract. In these types of circumstances, the obligee will also take out a payment bond in return.
While a performance bond guarantees the principal will complete their project, a payment bond means that the obligee will come through with payment. In either instance, if one party fails to uphold their end of the deal, the party on the losing end of the bargain isn't completely out of luck and can file for monetary compensation.
Sometimes, performance bonds are also used in commodity contracts. In this instance, it's meant to ensure that if a buyer pays for a commodity, said commodity will, in fact, be delivered in line with the terms of the agreement.
How Much Do Performance Bonds Cost?
The cost of a performance bond can vary depending on a variety of factors. Typically, it's a percentage of the overall price of the contract, usually between 1–5%. That said, the percentage may be higher or lower depending on the overall project cost outlined in the contract.
The creditworthiness of the principal (or contractor) is often a large factor when determining cost. Just like you can expect to pay a higher APR when applying for a credit card if you have poor credit, the same considerations come into play with performance bonds. The experience of the contractor may also come into play; more experienced companies with good track records are usually able to get better rates.
What's the Difference Between Insurance and Performance Bonds?
While performance bonds are often issued by insurance companies, they should not be confused with insurance. One of the main differences between insurance and performance bonds is who benefits from each type of coverage. For example, if the contractor applies for insurance, said insurance is intended to protect them in the event that something goes awry during the project. However, when the same contractor takes out a performance bond, that type of surety is intended to protect the party they have agreed to work for and doesn't necessarily benefit them in any financial way. (Though, of course, it can help them build trust with the party they're working with.)
The other — and perhaps largest — difference is that the whole point of insurance is that if the contractor needed to be reimbursed for an accident, the insurance company would pay them. If, however, a claim is filed on a performance bond that they took out, they would be expected to reimburse the surety.
Benefits and Pitfalls of Performance Bonds
While performance bonds are necessary under some circumstances, they do come with their own set of pros and cons. A few of the pros and cons include the following:
- The obligee has a guarantee that the project will be completed as expected.
- If the project is not completed as specified, the obligee can be reimbursed so that they will have the money to continue the project with another company.
- Requiring a performance bond for job bidding may keep some smaller and less expensive firms from bidding.
- Some sureties will attempt to avoid paying out on a performance bond based on technicalities or by claiming the obligee could have settled the issue less expensively.
- The obligee will have to prove why the project was not completed to specifications.
How to Get a Performance Bond
If you are looking to take out a performance bond on a project, it's important to do your research. These days, many surety companies will offer obligation-free quotes on their website, so it's worth shopping around for the best rates and coverage.
When you find the company you want to go with, you'll need to supply them with some pertinent information, including:
- Your CPA-prepared financial statements for at least the last two years.
- A copy of the contract.
- Any other application information they may give you.