Minimizing Construction Risks:
Why You Should Care If Your Contractor Is Bonded
Ever heard a contractor say they are licensed, bonded, and insured? You probably already know what licensed and insured mean, but do you know what the bonded part of that statement implies, or why it matters?
There are two main types of bonds a contractor can obtain for a construction project: a performance bond and a payment bond. A performance bond ensures your contractor will perform per the contract terms and conditions, at the agreed-upon price, and within the time allowed. A payment bond protects specific laborers, material suppliers and subcontractors against nonpayment by the contractor. New construction or capital improvement (renovation) projects frequently group the two bonds.
In short, a bond is a guarantee to perform the work as contracted. “A bond shifts the risks of a construction project from the owners to a surety (bond company),” says Sue Savio, President of Insurance Associates, Inc. “If a contractor defaults (e.g., going bankrupt, mismanaging the project and running out of money to complete it, running away to Mexico with your deposit, or losing key personnel needed to complete the project) then the bond could be called, and the surety would have to step in and complete the project for you.”
To qualify for a bond, a contractor must be in good financial standing. “Bond companies pre-qualify contractors by looking at their experience, financial history, current cash on hand, and credit available to complete a project. With this information, they decide up to what size and type of project they are willing to bond for them. This can be a pretty rigorous process requiring CPA prepared financials, detailed record-keeping, and commitments from the contractor to keep cash in the company that will be used to complete projects,” says Savio.
“Many decision-makers get caught up on the cost of bonds, but they can provide a level of protection that is appropriate for larger complex projects,” says Don Plank, a Community Association Loan Specialist with National Cooperative Bank (NCB). “It’s all about managing the risk of non-performance, and a contractor’s ability to get a bond provides good feedback related to their financial stability.”
For contractors in good standing, the cost of a payment and performance bond typically runs 1% to 3% of the total contract value. However, companies in financial distress may have to look at second tier bond markets with much higher rates.
Requiring a bond helps ensure your contractor has the size and financial stamina to do the work. Larger projects require higher outlays of cash by the contractor. More materials, more sub-contractors, and more labor can drive up a contractor’s out of pocket costs to get a job going, and with typical payment terms of 30 days, they can end up “floating” a lot of these costs until they get paid. A bond helps ensure the process continues to run smoothly and worry free. It also helps guard against smaller companies biting off more than they can chew, as smaller companies will be unable to get bonded for larger contract amounts.
“It’s all about managing the risk of non-performance, and a contractor’s ability to get a bond provides good feedback related to their financial stability.”
Community Association Loan Specialist
National Cooperative Bank (NCB)
“From a liability perspective, it’s much more secure for the community to hire a company that can easily bond their work, rather than taking a chance on a company that may be stretching to complete the job, or has had financial troubles in the past,” says Savio.
While not legally required for privately contracted work, it is recommended to have payment and performance bonds on any new construction or renovation project. For publicly funded projects, the Miller Act is a Federal Law requiring a bond for any construction project over $100,000 in total contract value.
Furthermore, when considering a contractor, you need to not only look at the bond for your particular project but also their total bonding capacity. Frequently, smaller contractors can obtain a bond for a single project, but if they look to take on two projects at once, they cannot get the total bonding capacity required for both jobs, putting one or both of the properties at risk. According to Insurance Associates, Inc., “sureties can also offer a bonding line of credit that a contractor can use between their various projects, so long as they do not exceed the cap set by the bonding company at any given time.”
“In the end,” says Savio, “having a bonded contractor ensures your project will be completed per the contract and that your contractor has been verified as capable to complete the project by a 3rd party surety. If the contractor is unable to complete the project, the bond company will make sure it happens for you.” All communities should consider bonding larger projects to protect their stakeholders’ interests in getting the project completed.