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Understanding the purpose of performance bonds and how they work is key to understanding why bad credit will affect performance bonds.
What Are Performance Bonds?
Performance bonds are a type of construction surety bond commonly required of contractors. Under the federal Miller Act, contractors working on federally funded contracts in excess of $150,000 are legally required to furnish the project owner with a performance bond, as well as a payment bond. Most states have enacted similar legislation (“Little” Miller Acts) requiring performance and payment bonds from contractors working on state-funded projects of $100,000 or more. And private project owners and lenders increasingly are requiring performance bonds and sometimes payment bonds from contractors working on larger projects.
The purpose of a performance bond is to protect the project owner financially if the contractor defaults on the contract and is unable to complete the job. One of the main reasons for default is a lack of capital to finish the job, which often is the result of faulty estimating and an overly optimistic profit forecast. It may also be due to overextension of the business and cashflow issues. A performance bond ensures that the project owner does not have to pay out of pocket to bail out the contractor or hire another contractor to finish the job.
How Do Performance Bonds Work?
When a contractor (the bond’s “principal”) is unable to complete a job, the project owner (the “obligee” requiring the bond) can file a claim with the bond’s guarantor (the “surety”). The surety will investigate the situation and determine whether it is valid. The principal is legally obligated by the terms of the surety bond agreement to pay all valid claims. But that’s not quite as straightforward as one might think.
In guaranteeing a performance bond, the surety agrees to lend the principal the funds needed to pay a valid claim, up to the total bond amount, which usually is the same as the total contract price. To honor that guarantee, the surety typically issues the payment directly to the obligee, paying the claim on the principal’s behalf. The principal is legally obligated to repay the resulting debt to the surety, but if payment is not forthcoming, the surety may need to take legal action against the principal to recover the amount of the claim.
Underwriting Concerns
The surety depends on an underwriting risk assessment to determine whether to provide an applicant with a performance bond and what the premium rate will be. The underwriters evaluate 1) the risk of the principal incurring a claim against the bond and 2) the risk of the principal not repaying the surety for a claim paid on the principal’s behalf. The assessment relies not only on information about the principal’s industry experience and history of prior claims, but also on an analysis of financial documents and financial capacity, along with a credit check. A creditworthy principal is perceived as a low risk to the surety and usually is assigned a low premium rate, perhaps as low as one percent.
Bad Credit Options for Performance Bonds
A contractor with poor credit is viewed as a much higher risk, which warrants a premium rate that could be as high as three or four percent. Not all surety companies will work with a high-risk contractor and simply decline the bond need, though some do offer bonding programs for contractors with bad credit. Sometimes a high-risk contractor can obtain a performance bond by putting up collateral in the amount required by the surety.
In some cases, a high-risk bond applicant may only be able to obtain a performance bond from a surety that participates in the Small Business Administration (SBA) Bond Guarantee Program, allowing the surety to provide performance bonds (as well as bid bonds and payment bonds) to contractors that otherwise might not be approved for a bond. A contractor who obtains an SBA-guaranteed bond will pay an SBA fee of .6% of the contract price in addition to the surety’s premium fee (1-3%).
To qualify for an SBA-guaranteed performance bond, a contractor must meet the SBA’s definition of a small business. The contract for which a bond is requested must be no more than $6.5 million for a non-federal job or up to $10 million for a federal project. Even with an SBA guarantee, the contractor must meet whatever qualification criteria the surety maintains for financial strength, capacity, and character. Albeit, these criteria standards may be view slightly differently by the surety due to the SBA’s 80-90% guarantee protection on the bonds.
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