If you’re new to the world of finance and contracts, you probably haven’t heard of the term surety bond before. But the deeper you delve, the more apparent its importance will become.
So, what exactly are surety bonds? And what are some of the things you have to know about them? We’ve made this short guide to introduce you to surety bonds basics. That way, if you ever need to purchase a bond, you’ll know exactly what you’re getting into.
What Are Surety Bonds?
To put it simply, a surety bond is a three-party agreement that acts as some sort of a safety net for one of the parties.
Imagine that you have entered into a contract with someone, but you’re not sure they can fulfill their obligations. In such a case, you’ll want some guarantee that they will do what they have promised, or at least that you’ll be compensated otherwise. That’s exactly where surety bonds come in.
As we said, a surety bond can only exist with three parties involved. They are:
- The obligee
- The principal
- The surety
To help you understand surety bonds better, as well as each party’s role in the whole agreement, let’s take a closer look at them individually.
The party that requires a surety bond as a guarantee against financial loss is called the obligee. Usually, the obligee is the one that sets the terms of the contract and expects the other party to meet their requirements. The obligees are most commonly government agencies that work with business owners or other professionals.
The principal is the party legally bound by a contract to fulfill specific requirements. To ensure they don’t suffer losses, the obligee will ask the principal to purchase a surety bond. Usually, the principal is a business owner or a contractor performing a certain job for the obligee.
Finally, the surety is the party that sells the bond and covers any potential losses the obligee might suffer. The surety is often an insurance company from which the principal purchased the bond. Ultimately, this party acts as a guarantor that the principal can fulfill the contract requirements or perform a job.
When Are Surety Bonds Required?
A party may require a surety bond if it has a reason to question the other party’s ability to meet the contract terms. However, that doesn’t always have to be the case. Sometimes surety bonds are used as a simple guarantee even between parties that trust each other. After all, doing business can be quite unpredictable, so all safety nets are welcome.
Surety Bond vs. Insurance
Though they may seem like two similar concepts, surety bonds, and insurance policies are quite different. The best way to understand this difference is to look at who bears the risk if things don’t go as planned.
When you purchase an insurance policy, its purpose is to protect you from risk. So if something actually goes wrong, your insurance company is the one bearing the responsibility of covering any losses. Of course, using your insurance to pay for the damages too many times will lead to higher premiums. But in the end, the insurance company is still the one that pays.
Surety bonds work in a different way, though. Their purpose is to protect the obligee, not the person or entity that bought them. Basically, if you purchase a surety bond, it’s still your responsibility to reimburse the obligee. But if your financial circumstances don’t allow you, the surety will cover the losses instead.
However, surety companies don’t want to suffer any losses, so they’ll likely ask you to sign an indemnity agreement. With that, they ensure that you have to pay them back even if they do reimburse the obligee instead of you. Thus, while sureties provide a guarantee to the obligee, they certainly don’t protect the principal.
How Much Do Surety Bonds Cost?
There is no fixed amount you need to pay to buy a surety bond. Actually, the cost largely depends on your needs and the kind of bond you choose. But typically, surety companies charge anywhere between 1% and 15% of the total bond amount. In other words, if you decide to purchase a $10,000 bond, you’ll pay between $100 and $1,500.
Much like when buying an insurance policy, the surety will usually assess your risk level and financial history before setting a price. Thus, if your risk is high and credit poor, you might even have to pay up to 20% of the total bond amount.
Which Industry Requires Surety Bonds Most Frequently?
The construction industry is, without a doubt, the industry that uses surety bonds most often. That’s because surety bonds are required for any public bids. Furthermore, they can ensure that businesses and professionals in this field don’t take advantage of their customers. In fact, the contractor bond is so prevalent in this industry that it’s often referred to as a construction bond.
Surety Bonds — Final Thoughts
Diving into the world of surety bonds and understanding its intricacies is not an easy task. Still, it’s extremely important to grasp what they’re all about — especially if you’re going to get one yourself. We’ve covered some of the basics here, but there’s much more to explore. So before you choose a surety company or a bond, make sure to do all the necessary research.