Today, we are going to discuss the advantages and drawbacks to both a surety bond and a LOC.
Let’s start with the advantages:
- Surety Bonds
- Since the creation of the surety bond does not go through a bank or financial institution, a surety bond can free up much-needed credit for a small business. Unlike the fees for a LOC, the fees for the development of a surety bond are not tied to current interest rates. Surety bond rates have been the same for the past 50 years. The increase to surety premium is strictly driven by the increased cost of each project.
- Surety bonds also do not require a commitment fee.
- Letters of Credit
- One of the primary advantages in using letters of credit lies in their application in international business. Banks in different countries can communicate with each other and establish rules for creating letters of credit. The letter of credit shows that a bank in Company A’s home country has certified the company’s credit worthiness. The bank in Company B’s home country can examine the document and communicate with the originating bank to verify that the letter of credit will be honored in that country.
There are also some disadvantages to each:
- Surety Bonds
- Surety bonds can increase the complications between a contractor and the bond owner. To settle any performance claims, the surety needs time to investigate where things are at on the project. This may create frustration as it may delay the project being completed by a deadline. In addition, the surety needs to investigate whether the default is truly the fault of the contractor. Surety companies have this responsibility legally, whereas with the LOC there is no defense.
- Contractors without a strong work history may find it difficult to obtain a surety bond. Since new companies lack the track record to qualify for full bonding, they may be forced into taking a smaller bond or doing a project without a surety bond. This may prevent the owner from getting competitive bids.
- Letters of Credit:
- The main drawback to a LOC is its lack of any defenses against a draw on the LOC. If a contractor fails to meet the terms of the letter, the issuer may pay off the letter, which will damage the contractor’s financial wherewithal. As the bank cannot exert any defenses against a draw on the LOC, this may put all parties in an adversarial position. Especially when the claimant of the LOC did not have good justification for claiming the draw on the LOC.
- In addition, where the fee structure for surety bonds is relatively stable, banks can charge a variety of fees. Bank fees for letters of credit will often move in step with interest rates.
- Letters of credit will also reflect on a company’s credit rating.
Over the past four blog posts, we have covered a lot of information while comparing surety bonds and a bank letters of credit. Goldleaf Surety Services is available to answer any questions you may have about these two credit instruments – or any of your bond questions!