What You Need to Know About Contract Bonds

definition, uses and purpose of this type of bond

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  1. A Contract Bond is a type of Surety

  2. A contract bond is a type of surety bond. A surety bond is a specialized type of three-party agreement. In this type of an agreement, one party (the surety) guarantees the performance of another party (the principal or Obligor) to a third party (the Obligee). The Obligor has to abide by the terms of the contract (which is why it is called a contract bond). The terms of the contract usually contain provisions as to what is being done, the quality of the work and the timeframe in which the work is to be completed. If the Obligor is unable to meet those terms, the Obligee has the option of "calling the bond." When that occurs and there is a valid claim, the surety is obligated to either finish the project according to the specifications or pay damages to the Obligee.
    This type of bond is generally used in the construction industry. The genesis behind the widespread use of surety bonds in the construction industry was the Miller Act. The Miller Act requires that any federal contract greater than $200,000 must have a surety bond. In addition, most states have passed "Little Miller Acts," which are statutes and regulations that generally mimic the federal rules
  3. What kinds of Contract Bonds are there?

    This type of bond is really a generic term that encompasses several types of more specific bonds. These bonds are such things as performance bonds, bid bonds, payments bonds and other types of specific bonds, like maintenance bonds.
    A performance bond is a bond where the surety guarantees the performance of the contract. This is probably the most common type of contract bond in the construction industry. The reason that this is so common is that a surety would prefer to have the ability to find another contractor to go in and finish the job. Usually, the job is not fully incomplete. Instead, just a portion is incomplete as the original contractor (the Obligor) has done quite a bit of work (as they don't want to default on a contract). So, the surety has the ability to find another qualified contract to go in, fix any problems with the job and complete the job. Then the surety can go after the original contractor for the cost of this completion.
    A payment bond is quite different. Here, the surety is guaranteeing that the original contractor has actually paid all of their material vendors, subcontractors and other obligations. The owner of the property wants this as they do not want to have a lien on the property. So, the surety is simply limited to paying them off and then their only recourse is to go after the contractor.
    A bid bond is a document that guarantees that the contractor is ready, willing and able to perform the terms of the contract if they are awarded the job. Most bid bonds have a damages clause, typically 10%, so that if they do not accept the job, they have to pay the damages.
    Cost of this type
    Most of these use a sliding scale to determine the rate. Given that the cost is usually a percentage of the total contract, the percentage rate declines as the total dollars increase. Most contract bonds in the United States range from one to five percent. For those that are under $500,000, the rate is typically around three percent.
    The cost of a bond can be decreased if the financial health of the contractor can be proven to the surety underwriters. Further, this rate can go down based upon a great history of performance and other good personal issues.
    Correspondingly, the rate is increased when there is more perceived risk. Having a history of non-performance, or a bad credit score, are all things that would increase the cost of a contract bond.

    Conclusion

    A contract bond is a type of surety bond. The most common types are performance, bid and payment bonds. They range in price from one percent to five percent of the job cost. You can learn more here.
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