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Performance Bonds vs Payment Bonds

April 23, 2022

Performance Bonds are often confused with Payment Bonds. Learn more about these two types of contract bonds, how they are different and how they are often used together.

 

What is a Performance Bond?

 

A Performance Bond is a type of contract surety bond. A performance bond guarantees that a project will be completed according to the contract. Performance Bonds are important to make sure that buildings are finished and not left incomplete.

 

These bonds are typically used in construction contracts but can guarantee many types of other obligations such as service contracts.

 

What is a Payment Bond?

 

A Payment Bond is also a type of contract surety bond. Unlike a performance bond, a Payment Bond is used to make sure that Subcontractors and Material Suppliers on the project are paid. These bonds are important because they ensure that a project will be free of mechanic's liens.

 

Performance Bond vs Payment Bond - This shows the difference between an performance bond and payment bond in a green box. In the background is a construction hardhat, hammer and blueprints.

 

Both Bonds are Required by Law

 

Federal construction contracts that are $150,000 or more require that the contractor post both Performance Bonds and Payment Bonds. This is required by The Miller Act

 

By requiring these bonds, the Federal Government makes sure their buildings are completed (Performance Bond) and that Subcontractors and Material Suppliers are paid (Payment Bond). This is very especially important on Federal projects as you cannot file mechanic's liens on Federal Buildings.

 

Additionally, most States and municipalities have adopted similar requirements for Performance Bonds and Payment Bonds on their projects. These are often referred to as "Little Miller Acts".

 

Costs of Performance Bonds vs Payment Bonds

 

Performance Bonds and Payment Bonds are rated the same way. These bonds are priced according to the size of the contracts they guarantee. 

 

Both performance bonds and payment bonds are often priced on a sliding scale where the rates get cheaper as the contract size increases. However, flat rates are common as well.

 

Typical pricing for both performance bonds and payment bonds range from 0.5 % of the contract amount to 4%. The price depends on the type of work, the financial strength of the contractor and the bond company's filed rates. 

 

You can read all about Performance Bond and Payment Bond Costs here.

Same Price for Both Performance Bonds and Payment Bonds 

 

Many parties do not realize that there is only one cost to have both a Performance Bond and a Payment Bond on a project. It really is twice the protection for one cost. From a cost standpoint, there is no reason to have both bonds on a project.

 

Underwriting 

 

Performance Bonds and Payment Bonds are underwritten using the "3Cs". These stand for Credit, Character, and Capacity. This takes into account a contractor’s financial strength, equipment, manpower, internal controls and previous history.

 

There are specific underwriting considerations for both Performance risks and Payment risks. As discussed, both performance bonds and payment bonds are required together on must Public work. When both bonds are required, the Surety bond underwriter has to analyze both the performance risk and the payment risk. Some private contracts only require one bond or the other, however.

 

Performance Bond Underwriting Risk

 

Performance specific risks include things like the type of work. For example, an underwriter may be concerned if a contractor is completing a project outside of their experience such as a school contractor trying to build a treatment plant. 

 

Experience could also apply to a contractor taking on a different trade such as a General Contractor performing concrete work for the first time.

 

Location could be another performance risk. Traveling to a new area carries additional risk for contractors and bond companies.

 

Payment Bond Underwriting Risk

 

Payment Bond specific risk could include things such as project financing. Often a contractor will not be able to pay subcontractors and suppliers if they are not paid themselves. Bond underwriters may want to know financing for the project is approved by the lender and set aside.

 

Another large risk is Payment terms. Bond underwriters look at contract terms and particularly scrutinize language such as contingent Payment clauses. These clauses often contain "pay if paid" or "pay when paid" language that presents risk to the contractor and payment bond.

 

Performance Bonds and Payment Bonds Require Indemnity

 

Both of these bonds are a type of contract surety bond and are not insurance. These bonds require the contractor to sign an indemnity agreement. If a surety bond company pays a valid claim on either a performance bond or payment bond, they will seek reimbursement from the contractor and any indemnitors.

 

It's easy to confuse Performance Bonds and Payment Bonds. In most cases both bonds are required together. Axcess Surety has expertise in all types of bonds and our experts are standing by to help answer questions and make the process easy. Contact us anytime.

 

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