Letter of Credit or Surety Bond: Meaning and Advantages

When starting a new construction and development project or applying for a license, one of the requirements might be to secure a Letter of Credit or Surety Bond. But, why are you required to get one of these policies? And which one is better to get?

Let’s start with defining both types of policies.

What is the definition of a Surety Bond?

A Surety Bond is a mixture of insurance and a line of credit. However, unlike traditional insurance, the Surety Bond is not in place to provide you coverage.

There are three parties associated with the bond.

The Principal – As the principal of the bond, you are responsible for making the surety whole again if they have to pay out on a valid claim.

The Obligee – This is the entity requiring you to get the bond. The Surety Bond serves as financial security for the obligee. If you, as the principal, fail to meet your duties outlined in the contract or perform inferior work, a claim can be made against your bond.

The Surety – As the surety company, they issue the Surety Bond to the principal. If a claim is made against the bond, the surety performs an investigation to determine the validity of the claim.

When you purchase a Surety Bond, you are guaranteeing to the obligee you’ll complete your job ethically and fulfill your contractual agreement. As stated above, the bond doesn’t serve to protect you as the principal.

What does it mean to get a Letter of Credit?

Similar to a Surety Bond, a Letter of Credit involves three parties.

The Financial Institute – Such as a bank or credit union. This is the entity issuing the Letter of Credit.

The Borrower – You are responsible for securing a Letter of Credit to provide to the beneficiary.

The Beneficiary – They are the entity requiring you, the borrower, to provide a Letter of Credit.

The Letter of Credit serves as your promise to the beneficiary that you’ll honor your contract and perform your job duties ethically. However, unlike a Surety Bond, you must have the full amount of funds available to get a Letter of Credit. When the financial institution issues this type of policy, they freeze your available liquid assets equal to the amount of the Letter of Credit.

How much are you expected to pay for these policies?

Surety Bond:

Don’t confuse the bond amount with the cost. As you will not need to pay the full bond amount to get your Surety Bond. In fact, most applicants with good credit typically pay between 1-3% of the bond amount. However, applicants with non-standard credit can still be approved for a bond at 5-15% of the bond amount set by the obligee.

Letter of Credit:

Just as the Surety Bond, you will not pay the full amount to get a Letter of Credit. Most likely, you won’t have to pay more than 1% of the amount you need to fulfill your contract obligation.

Although, unlike with a Surety Bond, you will need the total funds in your bank as collateral. Until the Letter of Credit expires, you are unable to access these funds.

What happens if a claim is made?

Regardless of the type of policy you choose, you’ll want to do everything in your power to avoid a claim. However, they do happen. So, knowing how claims are processed for your policy is important.

Surety Bond:

A claim can be made against your bond if you fail to fulfill an obligation within your contract, perform shoddy work or conduct unethical or dishonest actions. When the surety company holding your bond receives a claim against your bond, they will conduct an investigation.

Avoiding a payout on a claim is in the surety’s best interest, so they are thorough when determining the validity of a claim. Both the principal and the claimant are contacted by the surety to collect all the information, evidence and documentation before making a verdict.

The claimant receives a declination letter from the surety company if they determine the claim to not be valid. Conversely, the surety will payout up to the full bond amount to the claimant for a valid claim. The principal is responsible for repaying the surety company back in full for the payout.

Letter of Credit:

The Beneficiary may make a claim and collect on a Letter of Credit from the financial institution at any time prior to the expiration date. Documentation submitted by the beneficiary is the only documents the financial institution needs to verify are correct.

If the funds from the Letter of Credit doesn’t cover the entirety of the claim, the beneficiary must make a decision on which claimants are to be paid out, such as subcontractors, laborers, material suppliers, etc.

What are the advantages and disadvantages of both types of policies?

As stated above, you don’t need to have the full funds to purchase a Surety Bond. Even if you do have the available funds in full, you don’t have be concerned about having a large amount of your funds frozen in an account.

A Surety Bond is generally easier to get when compared to a Letter of Credit. You don’t need to have an established relationship with a surety company, whereas this is necessary for a Letter of Credit. However, you may end up paying more in premium with a Surety Bond, since a Letter of Credit typically doesn’t cost more than 1% of the amount required by the contract.

Who issues these types of policies? [When do they expire?]

A lending institution, such as a credit union or bank is able to issue a Letter of Credit. They will need to review your credit score and the number of projects you are to begin working on. A Letter of Credit is set to expire one year or later from the effective date.

When determining where to get your Letter of Credit, your best option will most likely be a bank or credit union you have an existing relationship with. An existing relationship with a financial institution is especially important if you don’t have a well-established credit history or good credit.

Getting a Surety Bond is quick and easy with Surety Solutions, A Gallagher Company’s online application. Start by selecting the state, type and amount you require for your bond. With just a little information, we can provide no-obligation quotes for your bond from leading surety companies.

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Most bonds are offered as a 1-year term. However, you’ll find we offer multi-year terms for a greater discount on many of our bonds.

If you have any questions, contact us online, via email at [email protected] or call (866) 722-9239. Our team of Surety Bond experts are always happy to assist with your questions.

Conclusion: Should you get a Surety Bond or Letter of Credit?

Getting a Surety Bond is typically easier and you don’t need to tie up a large amount of your funds. However, a Letter of Credit usually doesn’t cost more than 1% of the total amount needed and might be the less expensive option in the long run, if you don’t mind having your funds frozen in a bank account.

Both policies have pros and cons, so it comes down to what fits best with your business and financial situation. If you would like to view no-obligation quotes for a Surety Bond, you can do so here.

Helpful Resources:

Letter of Credit vs Surety Bond [Which is better for your business]

What is a Surety Bond?

How much does a Surety Bond cost?

About Surety Solutions, A Gallagher Company

Surety Solutions makes the process of getting your surety bond quick and easy. We’re committed to uphold our culture of trust, honesty and great customer service.

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Surety Bond vs Letter of Credit [Which should you get for your business]

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Beau Chipman

Beau is the Marketing Content Developer at Surety Solutions, A Gallagher Company. He creates content about all types of surety bonds, including mortgage, court, lost title, contractor, fidelity, ERISA and many more.

This Post Has 2 Comments

Laura Campbell says:

February 17, 2021 at 9:11 pm

What happens if a claim is made on a letter of credit?
1. Beau says:
  
  February 17, 2021 at 9:17 pm
  
  Hello Laura,
  
  Excellent question! A claim against a Letter of Credit can be made by the Beneficiary. The financial institution that issued the letter of credit will review any documentation submitted by the beneficiary to verify the claim is valid. The funds associated with the Letter of Credit will be dispersed among the claimants.

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