Surety bonds can look like a more expensive alternative to posting an irrevocable letter of credit. However, if you look deeper into the costs of each, it is clear surety bonds are the obvious choice. In this article we will review view an example to demonstrate the cost differences between the two. We will also go into depth on how a bank makes money off of a letter of credit versus how a bonding company makes money off of issuing a bond. After you have read this article you will want to make use of your surety credit whenever possible, as there are numerous benefits over letters of credit.
What is a letter of credit and how do they work?:
An irrevocable letter of credit (ILOC) is a letter addressed by a bank guaranteeing the account holder is “good for” a certain amount of funds. The letter of credit is held by the obligee. In the event of a claim, the obligee can draw on the funds held by the letter of credit. In order to ensure the account holder actually has the funds available to pay for a potential claim, a bank usually freezes the full amount of the ILOC in cash. In other words, if you need a $300,000 ILOC, then the bank usually holds onto the full $300,000, not allowing you to touch the funds until the ILOC is released.
What are surety bonds and how do they work?:
A surety bond is a three party agreement involving a principal (the party obtaining the bond), an obligee (the party requiring the bond of the principal), and a surety (the carrier backing the bond). The principal pays a service charge for the surety to guarantee performance. The principal makes use of the surety’s financial strength rather than having a bank hold onto their assets. Collateral is only required in high risk scenarios.
The REAL costs of letters of credit and surety bonds:
Often, people will argue that a letter of credit is less expensive than a surety bond and are therefore the better choice. However, people who believe this are not looking at the big picture. Lets take a look at a $100,000 example. An ILOC generally costs about 1%, or $1,000 a year. A typical surety bond rate in a standard market is about 1-3%, or $1,000 to $3,000 a year. When you just look at the up front costs, a bond is either the same or more than the ILOC. In order to make a true comparison, one must look at the real costs of an ILOC. Remember, a letter of credit requires you to tie up the full amount in cash where a bond typically requires no collateral. If you were to invest the capital you freed up by using a bond in a money market account you could currently make anywhere from 3-4%, or $3,000 to $4,000. This makes it so the true cost of a letter of credit raises to about $4,000 to $5,000 a year.
If you qualify, a surety bond is clearly a better choice over a letter of credit. A surety bond frees up capital that a letter of credit would otherwise tie up. Increased liquidity from surety bond use make day to day operations run smoother. A surety bond may seem to be the same price or more expensive at first look. Looking deeper, it is quite clear that a surety bond not only gives you more liquidity, but also at a cheaper price.