No construction project is without its challenges. A contractor might not have the resources to execute the job, or the market can delay shipments and drive up material costs. Many potential obstacles stand in the way—and as a result, a project owner’s finances might take a hit.
Owners should consider building construction bonds into their contracts to protect themselves from liability. Read on to learn what they are, why they’re essential, and which types of construction bonds might be needed.
What are construction bonds?
A construction bond protects project owners from financial loss if a contractor cannot fulfill the terms of a construction project.
Delays, material shortages, and faulty construction practices can incur unexpected costs that weren’t factored into the project’s budget. Construction bonds ensure the owner doesn’t suffer financial consequences as a result.
A contractor might fail to complete a project for many reasons. Perhaps they lack the labor capacity to get the job done, or they might not have the financial means to pay their suppliers and subcontractors. Some contractors will complete the project with subpar quality, while others might default on the project altogether. Of course, working only with trusted contractors can go a long way to avoiding these issues. Still, mistakes happen, especially in a volatile market. With construction bonds, no matter which term is violated, the owner can receive compensation by claiming the posted bond.
Three parties are involved in construction bonds. They include:
- The obligee: This is the person or entity protected by the construction bond. The obligee is usually the developer or a government agency that owns the project. If a contractor fails to meet the terms of a contract, the obligee can file a bond claim as compensation for damages or financial losses.
- The principal: Usually a builder or general contractor, the principal is the person or entity that purchases a construction bond. Principals manage the construction job to ensure laborers fulfill every contract term. The principal will become liable for any contract violations and must reimburse the full amount of the bond.
- The surety: The surety is a company that issues construction bonds. The surety will pay the bond amount to the obligee if a claim gets approved. While the surety is liable for contract violation payments, the principal must pay back the construction bond in full—usually based on a payment plan.
Types of construction bonds
Contractors may be required to purchase several different types of bonds before getting started on a project. The types of construction bonds they need depend on state laws and the terms outlined in their contract. The developer or project owner will decide which bonds are necessary. However, the contractor must purchase these bonds if they want to be selected for the job.
There are multiple common types of construction bonds:
- Bid bonds: Contractors often win construction jobs by bidding the lowest price. A bid bond guarantees the contractor will lock in that bidding price when they sign the contract. If the contractor charges more than the bidding price, the project owner can claim that bid bond as compensation for the unexpectedly high fee. A bid bond typically pays the difference between both bidding prices.
- Performance bonds: Once a contractor starts the job, their bid bond may be replaced with a performance bond. These bonds ensure the contractor fulfills the terms of the contract. They must provide the necessary materials, meet quality standards and complete the job within a specified timeframe. Performance bonds remain active for the duration of the construction job.
- Maintenance bonds: A maintenance bond comes into play following the completion of a project. Maintenance bonds guarantee that a contractor’s craftsmanship will last for a certain length of time before it needs maintenance. A project owner can claim this type of bond if the finished product is faulty or damaged or poses a risk to the end user’s safety. A maintenance bond will remain in effect during the entire warranty period.
- Payment bonds: A payment bond ensures the contractor will pay its workers on time and in full. Unlike the bond types mentioned above, a payment bond protects the subcontractors, suppliers, and employees who work for the contractor. If the contractor fails to pay one of these parties, the unpaid individual can claim a portion of the payment bond.
Why Owners Need Construction Bonds
It’s a smart idea for owners to require construction bonds in their contracts to prevent financial loss. Without construction bonds, a project owner would have to pay out of pocket to replace the contractor and redo the faulty or incomplete construction work.
Resolving a contract violation involves unexpected charges the owner might not be able to afford. Construction bonds compensate project owners so that they have the financial means to complete their projects.
A construction bond is also a mark of a reputable contractor.
Sureties have to pay the bond amount to project owners, so these companies issue bonds to contractors that will lower their liability risk. In addition, the surety will usually conduct a background check on the contractor, which involves assessing its labor capacity, financial stability, and success rate on previous projects. Owners want bonded contractors working on their projects because sureties trust them the most.
Assembling a team of bonded contractors will safeguard a developer’s budget against factors that are beyond their control. Construction bonds guarantee that no matter what happens, owners are able to complete the project while keeping their finances intact.