If you're wondering what a surety bond is, you're not alone. Most people have never even heard of surety bonds before being told they need one. Don't worry, though, because you've come to the right place! Whether you're an auto dealer, contractor, business owner or other working professional, this guide to bonding will help you on your way.
So how do surety bonds work, anyway?
To put it simply, surety bonds are insurance tools used to limit risk and financial loss. They guarantee that people do their jobs according to state laws, industry regulations and contractual expectations. Depending on how they're used, surety bonds can protect public tax dollars, private investments or consumer spending.
Regardless of its specific purpose, each surety bond joins three parties together into a legal agreement.
- The principal is the individual or business that purchases a bond to guarantee professional performance.
- The obligee, which is typically a government agency, requires the bond to minimize risk, limit financial loss and protect the general public.
- The surety is the insurance company that backs the principal by underwriting the bond.
If the principal fails to fulfill the bond's obligations, the harmed party can make a claim to gain reparation. If the claim is valid, the surety will provide compensation up to the bond amount.
Bond claims are rare because underwriters thoroughly review all applicants before issuing bonds. However, when claims are paid out, insurance companies require principals to repay them in full. This is how surety insurance differs from other types of insurance.
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What are common surety bond types?
You might be surprised to learn that thousands of individual surety bond types exist. This is because most government agencies establish regulations that require a unique surety bond form. Getting an auto dealer bond in California differs from getting the same bond in Florida. Fortunately, all of these different bonds can be lumped into one of three major categories.
If you're a working professional looking to get a bond for yourself or your business, you probably need a commercial bond. They're used to regulate markets and keep working professionals from taking part in fraud and other unethical business practices.
Most commercial bonds are license and permit bonds, which, as the name suggests, are required before government agencies issue a license or permit. Their purpose is usually to safeguard the public and keep the government from losing money. Government agencies in most states require the following types of license and permit surety bonds.
- Auto Dealer Bonds ensure dealerships operate according to state laws and regulations, especially those that prohibit fraudulent sales tactics.
- Contractor License Bonds guarantee that contractors will adhere to state and local laws and regulations. These are different from contract bonds and are typically filed with a contractor's license.
- Medicare (DMEPOS) Bonds aim to curb fraud and malpractice when suppliers of durable medical equipment, prosthetics, orthotics and suppliers bill Medicare.
- Mortgage Broker Bonds protect consumers from mortgage professionals who might try to take advantage of them.
- Sales Tax Bonds guarantee that businesses pay all applicable sales taxes to state and local government agencies.
Some commercial bond types aren't required by the government.
- Business Service Bonds protect clients from financial or property losses that could result from employees who work in their homes or businesses. These bonds are typically issued when an employer hires “high risk” employees.
- Janitorial Bonds work like Business Service Bonds, but they are used specifically for cleaning services.
- Utility Bonds guarantee that clients pay their utility bills in full and on time.
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As implied in the title, these bonds ensure contracts are completed according to their legal terms. Unfortunately, contract default does occur from time to time. When this happens, the bond's financial protection can keep project directors and taxpayers from losing their investments. Contract bonds are used for a few different reasons, but they're most commonly used in the construction industry.
The federal Miller Act requires bonds to be used on all publicly funded construction projects contracted for more than $100,000. Many states also have their own laws that require contractor bonding for public projects contracted for much less – some as little as $5,000.
Although dozens of contract bond types are used within the construction industry, three are used most frequently.
- Bid Bonds require contractors to enter into the contract if their bid for a project is chosen. If a contractor refuses to accept the contract, the bid bond allows the project developer to recover the difference between that bid and the next-lowest bid.
- Performance Bonds provide project owners and developers with financial protection in case a contractor fails to finish the project according to contract.
- Payment Bonds ensure that contractors will pay subcontractors, suppliers and laborers as detailed in the contract. Payment and Performance Bonds are sometimes issued together on a single form.
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Several different types of court bonds are used to protect businesses, communities and individuals in the face of criminal or civil tort litigation.
- Appeal Bonds guarantee that the original judgment will be paid if the appeal fails, which discourages people from filing appeals that waste the court's time.
- Guardianship/Custodian Bonds ensure that an appointed guardian will manage their charge's finances appropriately.
- Probate/Executor/Fiduciary Bonds require probates, executors and fiduciaries to distribute a deceased person's assets appropriately.
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How much do surety bonds cost?
Many factors affect how bond companies calculate premiums, so predicting an exact surety bond cost can be difficult unless an application is submitted. The bond type - including its amount, term and contractual risk - determines the complexity of the underwriting process. The applicant's credentials - including credit scores, past work history, references and professional reputation - indicates a principal's financial credibility.
Because they involve minimal risk, some bonds can be issued instantly without a financial review for a flat rate. Others involve application processes that require thorough financial reviews of credit scores and past claim history. Rates for applicants with credit scores of 700 or higher typically range from 1 to 4% of the bond amount. Generally speaking, this means that
- $10,000 of coverage costs $100 to $400
- $25,000 of coverage costs $250 to $1,000
- $50,000 of coverage costs $500 to $2,000
Applicants with credit scores below 650 pay more for bonds that require a credit check. This puts them in the nonstandard, bad credit surety market, which means they'll pay a rate that's anywhere from 5 to 20% of the bond amount. Generally speaking, this means that
- $10,000 of coverage costs $500 to $2,000
- $25,000 of coverage costs $1,250 to $5,000
- $50,000 of coverage costs $2,500 to $10,000
Sometimes applicants have trouble paying for the bonds they need. For some, surety bonds can be hidden costs that can even delay their business start-up plans. Fortunately, some surety providers provide premium financing options that allow them to pay for their bonds over time.