Contract Bond 101

A contract bond (also referred to as a contractor bond) is a type of surety bond typically held by construction contractors. What a contractor bond does, is it assures that if the construction contractor fails to complete a job or defaults on it in any way, then the owner of the project can file a claim against the bond for financial compensation.

Keep reading to better understand what contract bonds are, who needs this type of surety bond, and how they work.

What is a contract bond?

A contract bond ensures that a project will be completed following the conditions set forth in the contract. Essentially, this means that the construction contractor is liable to have a claim filed against their construction bond if they fail to complete the project or to complete it as promised. 

The owner of the project can file a claim against the contract bond and the surety (aka the company that issues the bond) would be responsible for investigating the claim. If the surety finds the claim to be valid, then they would pay out the claim up to the bonding capacity (the highest amount someone can claim against a surety bond). The construction contractor (also known as the principal) is not off the hook here. They have to pay the surety back the entire claim amount and may even owe additional interest or fees. 

What is a bonded contractor?

When discussing contract bonds, you’ll likely hear the term bonded contractor mentioned. Essentially, what a bonded contractor is, is someone who is licensed and bonded as a contractor in the state they work in. They will have obtained the necessary contractor bond or other types of surety bonds required for the project they are engaged in. 

In order to qualify for a contract bond, you typically need to be licensed as a contractor in the state you work in. 

Who Needs a Contract Bond?

Any contractors working on federal projects priced at $100,000 or more are required to hold a contract bond and this is also often the case when it comes to many state projects. Private projects can also require contract bonds. 

Throughout the course of a construction project, different types of surety bonds may be required. For instance, when a construction contractor is bidding on a major construction project, they may be required to hold a bid bond.

How do Contract Bonds Work?

The way that contract bonds work is that one party requires the bond (this is known as the obligee), one party needs the bond (the principal), and one party issues and secures the bond (the surety). In the case of contract bonds, the obligee can be the federal or state government or a private company and the principal is usually a construction contractor. 

Remember—if the project owner files a claim against a contract bond, then the surety has to investigate that claim. If the surety finds the claim to be valid, they’ll pay out the claim, but the principal will have to pay them back. 

How Much does a Contract Bond Cost?

Contract bonds typically cost 1% to 3% of the bonding capacity, which is the highest amount anyone can claim against the bond. Typically, the obligee sets the bonding capacity. So let’s say, the contract bond has a bonding capacity of $100,000 and the rate you’ll pay is 2%. That would lead to a bond premium of $2,000. 

The rate you will be offered is unique to you. The surety will take your personal and business finances into account, as well as your industry experience when determining the percentage to charge you. The more established your business is and the stronger your financial situation is, the lower the rate you’ll be offered. 

The most important factor when you apply for a contract bond is your personal credit score. The higher your credit score is, the more likely you’ll be to pay back the surety if a claim is filed against your bond. As a result, individuals with strong credit scores typically qualify for lower surety bond prices. 

To improve your credit score, it’s important to make consistent on-time payments to your debt, to have a long credit history, and to keep your credit utilization ratio low by paying off revolving forms of credit like credit card debt. Even if your credit score isn’t high when you first apply, you can work on improving it before you go to renew your contract bond at the end of the bond term so you can qualify for a better rate next time. Improving your credit score can also help you improve other areas of your financial life, so you stand a lot to gain by practicing good credit habits.