Payment bonds and performance bonds are two separate guarantees that protect different parties in a construction or service contract
A performance bond guarantees that a contractor will complete the work as promised. If the contractor fails to finish the job or walks away, the bond pays the project owner to hire someone else to complete it. A payment bond guarantees that the contractor will pay workers, suppliers, and subcontractors. If the contractor doesn't pay them, the bond pays those parties directly.
Both are common in construction, but they protect different people. The performance bond protects the person or company that hired the contractor. The payment bond protects the people and businesses that supplied labor and materials. On large public projects, both are often required by law. On private projects, they may be optional but are still common when the contract value is high.
The contractor buys the bond from a bonding company (called a surety). The surety charges a premium, usually a percentage of the contract value. If the bond is claimed, the surety investigates and pays out if the claim is valid. The contractor is then responsible for repaying the surety.
Key Takeaways
- A performance bond pays the project owner if the contractor fails to complete the work; a payment bond pays workers and suppliers if the contractor doesn't pay them.
- The contractor purchases the bond from a surety company and pays a premium, typically 1 to 3 percent of the contract value.
- Public construction projects usually require both bonds by law; private projects may require them depending on the contract size and terms.
- If a bond is claimed, the surety investigates and pays out if valid, and the contractor must repay the surety for the payout.
How a performance bond works
The project owner (called the obligee) requires the contractor (called the principal) to post a performance bond before work begins. The contractor contacts a bonding company and applies for the bond. The surety reviews the contractor's financial history, past projects, and credit to decide whether to issue the bond and at what cost.
If the contractor abandons the job, fails to meet deadlines, or delivers work that doesn't match the contract, the project owner can file a claim. The surety then investigates. If the claim is valid, the surety pays the project owner up to the bond amount. The project owner uses that money to hire another contractor to finish or fix the work. The original contractor is liable to the surety for the full payout plus investigation costs.
Performance bonds typically cover the full contract value. On a $500,000 construction project, the bond would be $500,000. The premium the contractor pays is usually 1 to 3 percent of that amount, depending on the contractor's track record and the project's complexity.
How a payment bond works
A payment bond protects workers, subcontractors, and material suppliers who work on a project but aren't paid by the general contractor. These parties can file a claim directly against the bond if they don't receive payment within a certain time (often 90 days after the work is done).
To file a claim, the worker or supplier must provide proof of the work performed or materials delivered and evidence that payment was not received. The surety investigates and pays the claim if it's valid. The contractor then owes the surety for the payout. Payment bonds are required on most public construction projects and are often required on private projects over a certain dollar amount.
Payment bonds protect people lower in the supply chain who have no direct contract with the project owner. Without a payment bond, a worker might have to sue the contractor to recover unpaid wages, which is expensive and time-consuming. The bond provides a faster path to payment.
When bonds are required
Federal law requires performance and payment bonds on all public construction projects over $150,000. Many states and cities have lower thresholds. Some require bonds on projects as small as $50,000 or $100,000. Private projects are not required by law to have bonds, but lenders, investors, or contract terms may demand them anyway.
Large private construction projects often include bond requirements in the contract. A homeowner hiring a contractor to build an addition might not require a bond. A commercial developer building a shopping center almost certainly will. The bond requirement is negotiated as part of the contract.
Contractors who regularly work on public projects must maintain bonding capacity. Bonding companies set a limit on how much work a contractor can bond at any given time. A contractor with $2 million in bonding capacity can take on multiple projects as long as the total doesn't exceed that limit.
The cost of bonds and who pays
The contractor pays the premium for the bond, which is typically 1 to 3 percent of the contract value. A contractor with a strong financial history and a clean track record pays closer to 1 percent. A newer contractor or one with past problems might pay 2 to 3 percent or higher. The surety sets the rate based on risk.
The contractor usually includes the bond cost in the bid price. So the project owner indirectly pays for the bond through the contract price. On public projects, the bond cost is built into the bid and is part of what the government agency pays. On private projects, the contractor may negotiate whether the bond cost is included in the bid or charged separately.
Bonding companies also require contractors to maintain certain financial reserves and insurance. They may require regular financial statements and project updates. These requirements are part of the surety's risk management.
What happens when a bond is claimed
The process begins when someone files a claim. For a performance bond, the project owner files the claim. For a payment bond, the worker or supplier files it. The claimant must provide documentation: the contract, proof of the work or materials, and evidence of the breach (non-completion or non-payment).
The surety investigates the claim, which can take weeks or months. They contact the contractor, review the contract terms, and verify the facts. If the claim is valid, the surety pays the claimant up to the bond amount. The contractor is then obligated to repay the surety. If the contractor cannot or will not repay, the surety may pursue legal action or place a lien on the contractor's assets.
A claim against a bond damages the contractor's reputation and bonding capacity. Future bonding companies will see the claim and may charge higher premiums or refuse to bond the contractor at all. This is why contractors take bond claims seriously and often settle disputes quickly to avoid a formal claim.
The difference between bonds and insurance
Bonds and insurance are often confused, but they work differently. Insurance protects the person who buys it. A performance bond protects the project owner, not the contractor. The contractor buys it, but the benefit goes to someone else. This is called a three-party agreement: the contractor (principal), the surety (bonding company), and the obligee (project owner or beneficiary).
Insurance also works on the principle of indemnity—the insurer pays for losses and the insured is not responsible for repayment. A bond works on the principle of may provide—the surety pays and the contractor is responsible for repayment. If a contractor's insurance covers a loss, the contractor doesn't have to repay the insurance company. If a surety pays a bond claim, the contractor must repay the surety.
Contractors typically carry both bonds and insurance. Insurance covers accidents, injuries, and property damage. Bonds cover contract performance and payment obligations.
Frequently Asked Questions
Can a contractor refuse to post a bond?
On public projects, no—bonds are required by law. On private projects, the contractor can refuse, but then they won't get the job. The project owner can choose to hire someone else or negotiate the bond requirement. Some contractors may offer alternative security, like a letter of credit, but most project owners prefer a bond.
What if the contractor goes out of business after a bond is posted?
The bond remains in effect. If a claim is filed and the contractor is no longer operating, the surety still investigates and pays valid claims. The surety may pursue the contractor's assets or insurance to recover the payout, but the claimant gets paid regardless.
How long does a bond stay in effect?
A performance bond typically stays in effect until the project is complete and accepted by the project owner, plus a warranty period (often one year). A payment bond typically stays in effect for one to two years after the project is complete, to allow time for claims to be filed. The exact terms are in the bond document.
Can a homeowner require a bond from a contractor?
Yes. There's no law preventing it. A homeowner can require a performance bond on a home renovation or addition if they want that protection. The contractor will charge more for the job to cover the bond cost, but the homeowner gets the security of knowing they can recover money if the work isn't finished.
What's the difference between a bid bond and a performance bond?
A bid bond guarantees that a contractor will enter into a contract if their bid is accepted. It protects the project owner during the bidding phase. A performance bond guarantees that the contractor will complete the work after the contract is signed. Bid bonds are smaller and are typically returned after the contract is awarded.