Payment Bond Definition: What is a Payment Bond?
In construction contracting, there are several components required of contractors who take on certain types of work. A surety bond is one of those requirements, as it offers protection for specific parties to the job should something not go as planned.
Payment bond definition: payment bonds are a type of surety bond that extends protection to subcontractors, vendors, and suppliers, ensuring they will get paid in line with the terms of the contract. Having a payment bond, often combined with a performance bond, is a necessary part of doing business on state or federal construction projects.
Just like other surety bonds, a payment bond offers certain protections to specific parties involved in a construction contract. As the contractor, you secure your payment bond from a surety agency to ensure the subcontractors, vendors, and suppliers, are paid. This is a three-party contract that gives the people who work on the contract the ability to make a claim to the surety agency if payment is not made.
When Do You Need a Payment Bond?
A payment bond is often a requirement when working on state or federal construction projects. Before a project begins, a payment bond is put in place so that payments are guaranteed to those working on the job. In many cases, a payment bond is combined with a performance bond, explained below, for a single rate.
Payment Bond vs. Performance Bond
Although many construction contractors use the terms payment bond and performance bond together, they are not one in the same. Let’s take a closer look at the difference between the two.
The difference between payment and performance bonds
A payment bond is meant to ensure the subcontractors, suppliers, vendors, and laborers on a specific project are paid as agreed per your project contract. If payment isn’t made on time or in full, a covered party of the bond may make a claim to recoup financial losses they incurred.
A performance bond, on the other hand, is a guarantee that the work promised in a contract is delivered adequately. If the project isn’t completed or the quality is less than what was agreed upon, a claim can be made to cover damages.
Both payment and performance bonds are required for many state and federal construction projects, and they are underwritten by a surety agency together in nearly all cases.
Can you get a payment bond only?
Because payment bonds are different from performance bonds, it is possible to get a payment bond without an attached performance bond. However, this is a rarity. Most construction projects on a state or federal level require both to be in place in order for a contractor to work on a project legally. In the rare cases where a performance bond is not also a requirement, a payment bond may be obtained on its own.
Payment Bond Cost
The cost of a payment bond is not the total amount of the bond required, but instead, it equals a percentage of the bond amount. This percentage is based on several factors and underwriting requirements, and bondholders may pay 1% to 4% depending on details included in the bond application.
Payment bond rates explained
The cost of a payment bond, represented as a percentage of the total bond amount, is known as your bond rate. Depending on the state in which you work, the project you need the bond for, and your personal credit history, bond rates will vary one contractor to the next. A surety agency may also take a look at your business financials to determine your bond rate. All of these factors come together to provide a clear picture of the risk you present to the surety agency. The lower your risk, the lower the rate of your bond in most cases.
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Credit scores and payment bond costs
Your credit score plays a vital role in the cost of your payment bond. Surety bond providers extend a form of credit to you when a new bond is issued. If a claim is made against the bond for non-payment, the bond provider pays for that claim. However, you as the bondholder may be required to repay that claim amount. If you have a low credit score, a surety agency may view you as a higher risk for repayment than someone who has a clean financial track record. To offset this risk, your bond rate may be higher.
Can you get a payment bond with bad credit?
Whether you have missed payments on credit accounts in the past, or experienced a bankruptcy, court judgment or foreclosure, a bad credit score does not mean you cannot get a payment bond. However, the process may take longer or require more documentation.
Fortunately, the right surety agency can work with you to get the payment bond you need even when credit is an issue. You may pay a higher rate for your bond initially, but you can work to improve your credit through on-time payments and responsible management of debts. These small steps can go a long way in reducing the cost of your payment bond for your next project.
How Do Payment Bonds Work?
The concept of a payment bond is simple when you understand who is involved in the process and how claims are managed over time.
The obligee, the principal, and the surety
A payment bond is a three-party contract including the following:
- The surety – this is the company that backs the bond you need
- The obligee – this is the general contractor or the government agency requiring the bond
- The principal – you as the contractor who is required to have a payment bond for a specific contract
When a claim is made against a payment bond because payment was either not made on time or at all, the surety company that provided your bond covers the claim amount, paid to the obligee. You as the principal may then be required to repay that claim amount back to the surety.
The Federal Miller Act
Payment bonds are mandated by the Miller Act, a federal regulation that is meant to protect suppliers, vendors, and subcontractors on federal construction projects. Under the law, all payments made on a contract valued at more than $100,000 are protected through a payment bond. In all cases, both a performance bond and a payment bond are needed to comply with the Miller Act on federal construction contracts.
How to Get a Payment Bond
Understanding what a payment bond is and how it works in the event of a claim is important to any construction contractor’s business. However, it is just as important to know how you can secure a payment bond when the time comes. The following steps lay out what’s needed so you can get the payment bond you need for state or federal construction projects.
Prepare and organize your documents
Getting a payment bond requires you to gather certain documents to submit along with your bond application. These items may include the following:
- Business balance sheet
- Income statement
- Cash flow statement
- Disclosures for the business
- Work schedules
- Personal and business tax returns
Your personal credit is also reviewed in the payment bond application process to ensure you are eligible for a new bond. A payment bond form, which we provide, is also required, which details what bond you need based on the specific project you are taking on. Having these documents together and organized is arguably the most important step of getting a payment bond when it is needed. It is often recommended that you work with an accountant who understands the construction business to help get your documents in order.
Obtain and sign the bond agreement
Once your application has been reviewed for accuracy along with your business and personal financial information, the surety agency provides a bond agreement after everything is approved. You will need to review this document and sign it for your records, and submit it back to the surety agency.
Cover the payment bond fees
The rate you pay for your payment bond is determined after a full review of your business and personal financial documents, your payment bond form, and other documents requested from the surety agency. Once approved for your bond, you will need to pay for your payment bond based on the rate provided to you.
Submit your payment surety bond
After paying for your bond and receiving the bond agreement, you will then submit your payment bond to the state or federal department responsible for ensuring payment bonds are in place.
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