Major construction projects can be risky for contractors and customers alike, especially projects being paid with taxpayer dollars. There's a chance the project may cost more than expected or that it will take longer than planned. That's why many government agencies and other organizations require contractors to obtain construction bonds, which help ensure the project will be completed according to plan. As a contractor, understanding how construction bonds work is key to keeping your budget in check and to serving your clients.

What Are Construction Bonds?

When a company or an organization needs a new building, they will contact construction companies in order to request a quote or proposal. Should they select your company as the winning proposal, they will want some assurance that the project will actually be completed as planned and that you will follow all applicable laws and rules. That's where construction bonds come in.

Bonds are like insurance policies that help protect the company or government agency from fraud, misconduct, business failures and other liabilities. When you take out a construction bond, you are helping to give your clients peace of mind because the bond helps to ensure that your company performs the work as agreed. Not only do bonds give your clients peace of mind, but in many cases, bonds are actually required by government agencies using public funds for construction work or other projects.

Generally, there are three parties involved in bonds: the company or organization that requested the construction work (the obligee), the company managing the construction work (the principal) and the company financially guaranteeing the bond (the surety).

How Do Construction Bonds Work?

Once your contracting or construction company is selected to perform work, you may be required to obtain surety bonds, especially if you are doing work for a government agency. The surety company will work with you to determine which types of bonds are needed for the project.

In general, the surety company will analyze the size of the job, the type of work being performed and your company's credit and financial statements to determine the risk associated with issuing bonds. This risk is how the surety company determines the cost of the bonds, which is typically 1 percent to 3 percent of the overall project cost.

After issuing bonds, the surety company will then require your company to sign an indemnity agreement, which is a legal document that requires you to pay for any claims that arise up to the full bond amount. The surety company will pay the claims first but then expects to be reimbursed by you, so it is important to ensure your company has enough assets in the bank to cover the bond amount if needed.

If you fail to complete a project as agreed, the organization that requested the work may make a claim against the bond. The surety company will make sure the organization is made whole by finding another contractor for the job, by making a financial payout or through some other means. Ultimately, however, you are fully responsible for the cost of any claims.

What Types of Construction Bonds Are There? 

There are several different types of construction bonds available. A bid bond serves as a guarantee that the proposal you submitted is accurate and that the job can be performed as described. If you back out after winning a job or if your proposal is inaccurate, a claim can be made against the bid bond.

After you are selected to perform work, you will likely be required to obtain performance bonds, which are required by law for all public work contracts over $100,000. A performance bond is a promise that the work will be performed according to the contract.

A payment bond guarantees that you will pay all subcontractors, laborers and specialists for their work on the job. You may also be required to obtain a maintenance bond, which acts as a warranty for a designated time period after the work is completed.

How Much Will This Cost? 

Because construction bonds are based on a percentage of the project cost, your cost for obtaining them will vary from project to project. It will also depend on your credit score. For instance, for a contractor with poor credit who has a 3 percent rate on a $500,000 bond, the cost would be $15,000. However, if your company has good credit and can obtain a 1 percent rate on the bond, the cost will be only $5,000. A smaller project of $150,000 would only run you $1,500 at that 1 percent rate, while a large $2,000,000 project would cost you $20,000. The best way to keep costs down for your contracting or construction company is to maintain good credit and only accept projects that are at or below the costs your budget can afford to cover.