How Does A Performance and Payment Bond Work?

Agencies or institutions that need a building or infrastructure constructed cannot just hire any contractor. They invite builders to bid for the project. This is done to make sure that the project is built at a low budget without sacrificing quality. Contractors have to work within the budget based on their bid amount. They cannot ask for additional amounts beyond the actual cost.

In order for contractors to religiously follow what has been stated in the contract, they are asked to provide several bonds. Once they fail to abide by the terms and conditions, the owner of the structure being built can use the bond to have other construction firms finish the task.

When a contractor wants to participate in the bidding, he must submit a bid bond. The bond is a guarantee that in case the bidder wins, he will accept the work and do it in accordance with the terms and conditions of the contract. When the bid winner will not do the task for whatever reason, the second lowest bidder will get it. The bid bond will be used by the owner to cover for the difference in the bid amount. For example, if the lowest bidder proposed a project cost of $300,000 and the second lowest bidder’s estimate is $350,000, the bid bond will be used to cover the difference of $50,000. Most contractors try to avoid losing this money so it seldom happens that they refuse to fulfill the contract.

Aside from the bid bond, the contractor will have to secure a performance bond and a payment bond. These two will guarantee that the project will be done according to what has been specified in the agreement and will be finished on the date that it is supposed to be finished.

What is a performance bond and payment bond? A performance bond is a protection for private entities or the Federal Government for whatever projects that they build. The contractor applies at an insurance company or a bank to purchase the bond. Usually, he must have collateral to secure it. If the contractor fails to meet his responsibility as a contractor, the project manager can demand to get the cash value of the bond so that the project can meet the quality standards in the agreement. The contractor will then pay back the bank or the insurance company.

The performance bond is usually 1% of the project cost for big projects while it is 3% or more for big ones. For big projects, the rate can go up. A contractor working on a $10,000,000 project will have to have a performance bond of $300,000 or more.

Insurance companies and banks can grant a contractor the required performance bond provided that he has collateral. He has to submit some documents, which are the copy of the contract, the completed surety application, and the detailed financial statements covering two years that have been prepared by a certified public accountant.

A payment bond is also required by the project owner. This is a guarantee that all subcontractors and suppliers of materials used in the construction can be paid even if the contractor declares bankruptcy. The payment bond is also 1% to 3% of the project cost.

How Does Performance Bond and Payment Bond Work?

A performance bond and payment bond protect the project owner from losses that can be incurred when the contractor declares bankruptcy and fails to complete the work or when he cannot deliver the quality agreed upon.

The performance bond can only be released to the owner of the structure being constructed. He will use this to hire someone else who can meet the quality standards specified in the agreement.

On the other hand, the payment bond can only be released to the project manager so that he can pay the subcontractors and the suppliers of the materials that have been used for the building.

Both bonds assure the owner that construction will be completed and that he will not have to shoulder extra costs.

Project owners must make sure that the contract is clear and specific. If not, they might not be able to get the exact amount of the bond. The company or bank where the contractor purchased the bond will do everything to reduce the amount.

For performance bond and payment bond to work well for the project owner, he must see to it that all costs are clearly presented. He must itemize his losses so that he can get the whole amount of the bond.