Construction Bonds

Many construction projects today require that contractors provide bonds. Construction bonds are protection for the owner against non-payment, lack of performance, company default, and warranty issues. There are several types of construction bonds available. In fact, there are so many that they may make your head spin (but don’t worry — you’ll most likely never run into them all). But how do construction bonds work?

We’ll look at several types of bonds in the construction industry, breaking down who buys them, who can make claims, and how much they cost. We’ll also look at what it takes to get a bond and how to make a claim, if you need to.

How do construction bonds work?

It can be helpful to think of a construction bond as an insurance policy, even though it’s a bit different. A contractor purchases a bond to protect himself and/or the project owner from potential financial issues during the project. If a problem occurs, the owner can file a claim with the insurer, and the company will pay the owner, recouping any additional expenses they incurred due to the default.

What is a construction bond? A construction bond provides financial security on a project. A bond is essentially guarantee that the contractor or supplier who purchases it will follow through on their contract requirements.
What is a construction bond? A construction bond provides financial security on a project. A bond is essentially guarantee that the contractor or supplier who purchases it will follow through on their contract requirements.

Unlike insurance, however, once a bond claim is paid to a project owner, the contractor must pay the surety back for any money they paid out on the contractor’s behalf. The surety will generally work with the contractor to create a payment plan that works for them.

A construction bond is also known as a contract bond, because it guarantees that the purchaser will fulfill the terms of the contract.

Chart reading: People affected by a bond include the obligee (the party protected by the bond), the principal (the contractor or supplier who purchases the bond), and the surety (the company that provides/sells the bond).
People affected by a bond include the obligee (the party protected by the bond), the principal (the contractor or supplier who purchases the bond), and the surety (the company that provides/sells the bond).

Parties to a bond

There are three main parties to a bond:

  • Principal
  • Surety company
  • Obligee

The principal is the person or company purchasing the bond. On most projects, this is usually the general contractor or a subcontractor.

The surety company provides the bond for the project. This is the one who is responsible for paying any claims that are filed.

The obligee is the person or company who would get paid if there was a problem on the job. This party varies based on the type of construction bond. The obligee for a payment bond is typically a subcontractor or supplier, while the obligee for a performance bond is usually the property owner.

Why do contractors need a construction bond?

Contractors may need a construction bond when working on a specific type of project, as seen below. Particularly with large projects, the bond acts as an agreement between the contractor and project owner assuring the contractor will fulfill all the terms. Contractors are charged for the bond based on their financial health as well as their past job record.

Projects that require construction bonds
Projects that require construction bonds include federal projects valued over $150,000, public projects specified under each state’s “Little Miller Act,” and any private projects determined by the project owner.

Public vs. private projects

Bonds are generally required on all federal projects, especially those over $100,000. All government projects that fall under the Federal Miller Act or state Little Miller Acts will require payment and performance bonds at a minimum. State and local public entities may also have their own thresholds for when bonds are required.

Any project owner, whether public or private, can ask that contractors or suppliers provide surety bonds for any construction project. The cost of the bonds is usually added to the contract price, as it is an additional item that the owner is requesting.

Why are surety bonds used on construction projects?

Bonds are used on construction projects whenever the owner wants additional financial protection during a project. While construction contracts usually have provisions for what to do if a contractor fails to complete a project, there is no financial protection for the owner in that situation. This could lead to additional costs that would need to pay to complete the project after the default.

By requiring bonds, the owner protects him or herself from any additional costs caused by the default of a contractor. This is especially important when the owner is using public money. That is often why bonds are required on projects using public funds.

Common types of construction bonds
The common types of construction bonds include performance bonds, payment bonds, bid bonds, maintenance bonds, license bonds, retention bonds, and supply bonds.

Video: 3 Main Types of Construction Bonds

Types of construction bonds

Payment bonds

Payment bonds protects the property owner from mechanics lien claims or other claims against the property title for non-payment. They also protect the subcontractors and suppliers on the project, ensuring that they get paid for the work they do.

A payment bond guarantees that the principal (e.g., the GC) will pay their lower tier subcontractors, laborers, and suppliers. Payment bonds are required on most public projects. They may also be required by private owners when desired.

Under a GC’s payment bond, the subcontractors and suppliers are the obligees. If the GC fails to make payment in a timely manner, subcontractors and suppliers can make a claim against the payment bond. These bond claims are filed in place of mechanics liens, which generally can’t be placed on public property.

A payment bond is one of the few types of construction bonds where the beneficiary (obligee) is in a lower tier than the principal purchasing the bond.

The cost for a payment bond is typically about 3% of the value of the contract, depending on the credit history and financial standing of the contractor.

Mechanics lien bond

A mechanics lien bonds are used after a contractor or supplier has filed a mechanics lien on the property. They may also be called lien release bonds or discharge of mechanics lien bonds. They are used in the process of bonding off a mechanics lien. A mechanics lien bond removes the mechanics lien claim from the property itself, and attaches it to the bond instead.

The cost for a mechanics lien bond is generally 1 – 5% of the bond amount.

Performance bond

Performance bonds guarantee that a contractor will perform the work according to the conditions and requirements of the construction contract. They protect the owner from contractor default in the middle of a project and then having to pay someone else more to come in and complete it. Performance bonds also protect the owner from substandard work, or work that doesn’t meet the contract requirements. They are usually required on public projects and can be requested by any private owner.

These bonds are held by the project owner as obligee, with the GC or a subcontractor as the principal. The project owner makes a claim against a performance bond if there is a question about the quality of the work or whether the work will be finished according to the contract requirements. A GC can also make a claim on a subcontractor’s performance bond for the same reason.

Performance bonds generally cost between 1-3% of the total contract price.

Bid bond

Bid bonds provide reassurance to a project owner that a contractor will follow through with their bid, and sign a contract for the bid amount if they are awarded the project. A bid bond keeps a GC from backing out of a deal after finding out how much other contractors bid. It also protects the owner if the GC forgot to include something in their bid, as they are obligated to sign a contract for the amount they listed. If they aren’t able to complete the contract as bid, the surety pays the difference.

Like performance and payment bonds, these bonds are made out to the project owner and are provided by the general contractor as principal. If a claim needs to be made, the owner is responsible for notifying the surety company.

Bid bonds are inexpensive, usually a few hundred dollars. Some sureties don’t even charge for a bid bond, since they often lead to purchasing performance and payment bonds.

License bond

Contractor license bonds can be required by state licensing boards and are different from other bonds, in that they don’t guarantee work specifically. They provide assurance to the contractor’s clients that the contractor is, and will remain, in compliance with state laws. The bond protects consumers from financial loss when they have a claim against a contractor for substandard or incomplete work.

These bonds are also different in that usually the obligee is the contractor’s board, and the board is usually responsible for making a claim against a license bond. If a consumer has a complaint, they file a claim with the contractor’s board, who then files against the contractor’s license bond.

License bonds cost about 1% of the bond amount, which is set by each state’s contractor licensing agency.

Check out the comprehensive guide to contractor license bonds.

Subdivision bond

Subdivision bonds guarantee that a developer or contractor will make improvements to the land in a subdivision as per its agreement with the local jurisdiction. Improvements can include things like sidewalk maintenance, electrical upgrades, or grading changes.

The jurisdiction sets the bond amount and how soon the work needs to be completed. If a claim needs to be made, the jurisdiction would be the one filing a claim.

These bonds usually cost about 3% of the amount of the bond.

Supply bond

Supply bonds ensure that building supplies or materials will be provided to a project. The supplier provides this bond to the GC or owner, and it protects them from default by the supplier. These types of bonds are often required on public projects.

The cost of a supply bond will depend on the financial status of the supplier.

Maintenance bond & warranty bond

Maintenance or warranty bonds guarantee the project owner or a local jurisdiction that there will be no faults or defects in a certain improvement for a certain length of time. These bonds are often required when doing work on public infrastructure, such as sewer lines, storm pipes, or water mains.

If repair or replacement is needed within the time frame set by the jurisdiction and the contractor does not complete the work, then the jurisdiction will file a claim with the bonding company for any expenses they incurred.

Bond costs depend on the financial status of the contractor.

Completion bond

Completion bonds provide assurance for the project owner that the project will be completed on-time, within budget, and free of liens. They differ from performance bonds because they cover the completion of the project as a whole, not just a specific contract. Both completion and performance bonds can be required on the same project. The project owner is responsible for making a claim if the project is not completed correctly. Bond costs range between 1-3% of the total project amount.

Public works bond

Public works bonds are generally required for any work on a state public works project. Each state has its own bond amount that is required for work on these projects. These bonds also guarantee that workers will be paid correctly according to prevailing wage requirements, and the state may use these bonds to enforce those requirements.

The state is the obligee on public works bonds and is responsible for pursuing any claims.

The cost of a public works bond will depend on the financial status and past performance of the contractor.

Retention bond

Retention bonds replace the withholding of retainage on a construction project. Instead of letting the GC hold 5-10% of every payment, the subcontractor can purchase a retention bond to guarantee that all work will be completed at the end of the project. A retention bond can help a subcontractor get their full progress payment in each period, without having to wait for retainage after the project is complete.

Depending on the cost of the bond, it may be a significant savings for a contractor over the life of a project. The project owner is responsible for making any claims for work that wasn’t completed.

The cost of the bond will depend on the financial status and past performance of the contractor.

How to get a bond, payment bond process

Getting a construction bond

When your company needs to purchase a bond, the first place you should start is with a surety company. A surety will provide the bond and pay any claims that may arise. You can often get a list of surety companies from your insurance agency, or you can look for a company specializing in construction bonds. Using an agency is preferred, because you generally only have to fill out one application and they will do the shopping for you, providing you with the best options for your situation.

Risk assessment

Once you have completed the bond application, you will need to submit some additional documentation so the surety companies can assess how risky you are. These documents will include financial statements, work history, project references, and other documents. Make sure these documents are accurate and up to date, as this will speed up the review process.

The surety underwriter will evaluate several factors, including your financial situation, your capacity to do the work of the proposed project, and the status of your previous projects.

After your documents have been reviewed and you have been approved, you will select a surety based on the proposals, and then the bond will be issued and sent to the obligee.

Construction Bonds Infographic Thumbnail

Illustrated Guide to Construction Bonds & How They Work

Download an infographic that explains common types of bonds in construction and how they work.

Download the infographic

Making a bond claim

If the work is not complete, the contractor defaults, or payments are not being made, the obligee can make a claim against the bond. The surety company will do an investigation of the claim, contacting the principal to verify facts and amounts. If the claim is justified, the surety will pay the obligee the amount requested.

After a claim has been satisfied, the surety will then look to the principal for repayment of any expenses.

How to get the surety information

If you need to make a claim on a contractor’s bond, you will need the name and contact information for the surety company and the bond number in order to file a bond claim. The easiest way to get the bond information is to simply ask. You can ask the project owner for the bond information, or ask the GC directly.

It’s best to ask for the bond information at the beginning of a construction job, when requesting information for preliminary notices. If you only request bond information when you’re ready to file a claim, the principal may be less forthcoming.

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Managing risk with construction bonds

Construction bonds are risk management tools that contractors and suppliers can use on a variety of projects. They help protect construction parties from financial injury, and ensure that the project is completed in a timely fashion.

When used correctly, surety bonds can benefit all parties on a construction project. The cost of a bond is often well worth the peace of mind, knowing that there won’t be any additional costs caused by non-payment, default, or non-performance.

Read more: Insurance vs. Bonds: What Contractors Need to Know

Construction bonds explained in a simple infographic

Construction bonds explained in an infographic
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