Over the next several blog posts, we will explore surety bonds and bank letters of credit – what each is, their differences, and the advantages and drawbacks to each.
Let’s start with a basic definition for each.
- A surety bond is a three-party agreement between the surety company, the oblige (project owner), and the principal (the contractor). A performance bond protects the owner from non-performance and financial exposures should the contractor default. A payment bond (or labor and material bond), protects certain subcontractors, laborers, and material suppliers against non payment by the contractor
- A bank letter of credit (LOC) is a cash guarantee to the owner who can call on the LOC on demand. The LOC converts to a payment to the owners and an interest-bearing loan for the contractor. The performance of the contract has no bearing on the bank’s obligation to pay on the letter of credit.
How do you pre-qualify for these instruments?
- With a surety bond, Goldleaf Surety Services together with the surety company assess the contractor’s business operations, financial resources, experience, organization, existing workload, its profitability, and management capability to verify the contractor is capable of performing the contact. The purpose is to avoid default.
- With a bank letter of credit, the banker examines the quality and liquidity of the collateral in case there is a demand on the letter of credit. If the bank is satisfied that the contractor can repay the bank if demand is made upon the LOC, there is no further prequalification.
In the next blog post we will discuss borrowing capacity, duration, how to obtain, and cost for each.