Construction Bond Definition, How It Works, Requirements, Types

What Is a Construction Bond?

A construction bond is a type of surety bond used by investors in construction projects. Construction bonds are a type of surety bond that protects against disruptions or financial loss due to a contractor's failure to complete a project or failure to meet contract specifications. These bonds ensure a construction project’s bills will get paid. 

How a Construction Bond Works

Construction bond, also known as a contractor license bond, is a required bond for a construction project. A contractor is required to have construction bonds for nearly all government and public works projects. A contractor vying for a construction job is generally required to put up a contract bond or construction bond. 

The construction bond provides assurance to the project owner that the contractor will perform according to the terms stated in the agreement. Construction bonds may come in two parts on larger projects: One to protect against overall job incompletion, and the other to protect against nonpayment of materials from suppliers and labor from subcontractors. 

There are generally three parties involved in a construction bond:

• The investor/project owners, also known as the obligee.
• The party or parties building the project.
• The surety company that backs the bond.

The project owner or investor is typically a government agency that lists a contractual job it wants to be done. To reduce the likelihood of a financial loss, the obligee requires all contractors to put up a bond. The contractor selected for the job is usually the one with the lowest bid price since investors want to pay the lowest amount possible for any contract.

By submitting a construction bond, a principal—that is the party managing the construction work—is stating that they can complete the job according to the contractual policy. The principal provides financial and quality assurance to the obligee that not only does he have the financial means to manage the project but that the construction will be carried out to the highest quality specified. The contractor purchases a construction bond from a surety which runs extensive background and financial checks on a contractor before approving a bond.

Special Considerations 

When a contractor fails to abide by any of the conditions of the contract, the surety and contractor are both held liable. The owner can make a claim against the construction bond to compensate it for any financial loss that ensues if the principal fails to deliver on the project as agreed or for costs due to damaged or defective work done by the principal. In cases where the contractor defaults or declares bankruptcy, the surety is held responsible for compensating the project owner for any financial loss. A surety that takes on the liability of a claim can sue the contractor for the amount paid to the owner if the terms of the construction bond permit it. 

Requirements for Construction Bonds

Companies that get construction bonds generally follow these steps:

• Reviewing job requirements to see if a construction or contract bond is needed.
• Getting a bid bond from the surety agent and submitting it with the proposal.
• If awarded a contract, approaching the agent for a performance bond.
• Completing the job.
• Getting a maintenance bond, if required, once the job is completed to do any repairs.

Most government jobs require the use of a construction bond. However, there are some lines of work that don't qualify for construction bonds from American companies even when the job may be posted by the government. Any projects that take place overseas or on Indian reserves, projects involving private home remodeling, or even multi-year construction projects will not receive construction bonds. 

Many U.S.-based surety companies may consider these projects too risky to insure. Laws, rules, and regulations may differ internationally or on native reservations, leaving the surety company in a rut if the contractor either doesn't complete the job or violates the terms of the contract. And contractors may not qualify to do the work cited after a certain period of time, which makes it difficult to bond a longer-term project.

Construction Bond Types

A surety bond is the financial guarantor of a construction bond, guaranteeing the obligee that the contractor will act in accordance with the terms established by the bond. Surety companies will evaluate the financial merits of the principal builder and charge a premium according to their calculated likelihood that an adverse event will occur.

A surety can assist a contractor in having cash flow problems and may also replace a contractor who abandons a project. There are three main types of construction bond provided by a surety:

Bid Bond

A bid bond is necessary for the competitive process bidding. Each contending contractor has to submit a bid bond along with their bids to protect the project owner in the event a contractor backs out of the contract after winning the bid or fails to provide a performance bid, which is required to start working on the project.

Performance Bond

A bid bond is replaced by a performance bond when a contractor accepts a bid and proceeds to work on the project. The performance bond protects the owner from financial loss if the contractor’s work is subpar, defective, and not in accordance with the terms and conditions laid out in the agreed contract.

Payment Bond

This bond is also called a labor and material payment bond, which is a guarantee that the winning contractor has the financial means to compensate their workers, subcontractors, and suppliers of materials.