How Surety Bonds Protect the Construction Industry
Without surety bonds, construction projects may be delayed, poorly executed, or left unfinished. Construction bonds reduce risk and lower costs by holding contractors financially accountable for their obligations.
Keep scrolling to learn more about how construction surety bonds improve project quality while reducing investment risk.
When Were Bonds Introduced in Construction?
Public works contractors didn’t have bond requirements until 1894, when the Heard Act was introduced to protect federal construction projects.
The Heard Act was then replaced by the Miller Act in 1935, which clarified contractors’ responsibilities. It also established two separate bond requirements:
- Performance Bonds: Ensure project completion
- Payment Bonds: Guarantee that subcontractors and suppliers get paid
What are the Federal and State Bond Requirements?
Under the Miller Act, contractors working on federal construction projects valued over $150,000 must file a bond.
Individual states have their own versions of the Miller Act, referred to as “Little Miller Acts.” These apply to state and local public works projects.
While not required by law, private owners can also choose to require surety bonds to protect their investment and reduce financial risk.
How Do Construction Bonds Work?
While traditional insurance protects the contractor, construction bonds protect the project owner’s investment. Bonds hold the contractor financially liable for completing their work.
A construction bond is a legally-binding contract between three parties:
- Principal: The contractor filing the bond
- Obligee: The government agency or project owner requiring the bond
- Surety: The provider issuing the bond
The project owner or government agency requires the contractor to purchase a bond before construction begins. The bond amount and terms depend on the specific project.
The contractor then pays the surety bond company a premium for issuing the bond, typically a small percentage of the total bonded amount.
If the contractor fails to uphold any part of the contract, the owner can file a bond claim. The surety company will pay out valid claims up to the full bond amount. However, the contractor is ultimately responsible for refunding the surety.
Who Needs a Construction Bond?
Contractors often need surety bonds to fulfill contracts, ensure compliance and meet legal obligations. A project owner or government agency may require one for a specific project.
A bond is also required when working on public construction contracts, with project value thresholds determined by the Miller and Little Miller Acts.
How Bonds Lower Costs While Improving Project Quality
Construction projects are costly and risky. Delays, defaults or poor workmanship can easily ruin a project’s completion.
Surety bonds offer financial protection to avoid these issues. Bonded contractors lower costs while ensuring higher project quality.
Reduced Financial Risk
When a contractor is bonded, the project owner is financially protected if they can’t complete the job as agreed. This allows developers to securely take on more ambitious or costly projects.
Bonds also lower the risk of default, since the surety company will step in to cover any financial loss and ensure project completion.
Financial security prevents costly project interruptions, delays or disputes. According to a 2023 Ernst & Young survey, unbonded projects have an 85% higher completion cost than bonded ones.
Better Financing and Lower Costs
Because bonded projects hold contractors financially liable for their obligations, they’re seen as more secure investments. This makes them easier to finance. Lenders and stakeholders know that resources will be available, even if the contractor fails to perform.
This added stability also helps lower contractor pricing. According to the E&Y survey, surety bonds reduce contractor pricing by an average of 3.2% of the project value, with 75% of owners surveyed agreeing that bonding keeps pricing competitive.
Increased Project Quality Through Prescreening
Surety companies thoroughly examine contractors’ qualifications before issuing bonds, including their financial stability and past performance. Only reliable contractors are approved to work on bonded projects to reduce the risk of claims.
This means that bonded contractors undergo more rigorous review, assuring owners that they’re reliable and qualified.
Thorough prescreening leads to higher-quality workmanship and fewer costly errors. Bonded projects require more oversight, so contractors are incentivized to meet deadlines and deliver results on time.
Construction Bonds Also Benefit Contractors
When a contractor gets approved for a construction bond, it shows project owners that they’re reliable and a good choice for the job. This can increase contractors’ professional opportunities.
Subcontractors also benefit from working for bonded contractors. They are guaranteed payment, even if a general contractor goes bankrupt.
Instead of filing a mechanic’s lien to receive payment, the surety steps in to cover their costs. This is especially important for public projects, since subcontractors can only file mechanic’s liens on private property.
What are the Different Types of Construction Bonds?
There are three main types of construction bonds:
- Bid Bond: Confirms that a contractor is qualified and capable of accepting a job at the quoted price
- Payment Bond: Guarantees payment for services and supplies if lead contractors go bankrupt or default on a project
- Performance Bond: Ensures the contractor completes the project according to contract terms
Learn more about other types of construction bonds in our complete guide.
