What Is a Performance Bond?

Business Knowledge

A performance bond provides or gives a guarantee to the project, that the contractor or holder of the contract will complete his work according to the project owner’s terms and conditions and if the contractor will not able to complete the project then all failures contractor will handle and meet the obligation of the project. The main purpose of the performance bond is to give financial protection to the project. This type of bond is mainly provided by the bank, insurance company to the project owner on the behalf of the contractor. 

Performance bonds are mainly popular in the construction industry and the real estate industry where development will be done on a contract basis. Mainly performance bonds are needed in the government sector which work is done on a contract basis, but nowadays private sector is also using this type of bond.  Performance bonds are also known as surety bonds. 

Types of parties come under Performance Bond

There are three parties that come under the performance bond: 

  • Principal: The principal is the person or contractor who will do or accomplish the work. In this primary person is responsible for the development of the work 
  • Obligee: The obligee is the owner of the project and who can speak about the project. Obligee can be a company, individual or governmental organization that is having receipt of the project. 
  • Surety: The surety is the bank, an insurance company that gives the performance bond. 

A performance bond is not the coverage of the project. It is just like a protection bond that is issued by the bank, an insurance company to the project owner. This bond will provide surety to the project owner if the contractor will not do work according to specified terms then the obligee will pay the whole amount of the project. This performance bond is only given to financially stable companies. 

Working of Performance Bond

Performance bonds are mainly used in the government sector which different types of construction contracts are given to contractors like the building of the bridge, road, etc. but now performance bond is also popular in the pirate sector also, where construction work is done on the contract basis. The performance bond provides protection in this situation:

  • When the contractor is failed to deliver the work on the specified deadline.
  • This bond protects us when a contractor declares bankruptcy.

Documents Needed when applying for a performance bond

Following types of documents and information required when  you are going to applying for a performance bond: 

  • Last Two years of financial statements.
  • Copy of the contract because of that the performance bond is tied.
  • Application of surety.
  • Real estate assets document which is owned by the contractor. 

If the contractor is not able to complete the project, the surety company will pay the cost or hire the new contractor to complete the project or provide some compensation amount to the obligee and allow the obligee to complete the work.

Pros of Performance Bond

These are some benefits of using a performance bond: 

  • The obligee is always had surety that the project will be completed
  • Assurance of the project 
  • There is no additional funding required to complete the project.

Cons of Performance Bond 

  • Surety company have to pay all cost of the project if development does go according to terms and conditions
  • Surety companies trying to settle the amount at a lesser cost, so that they will save some expenses.
  • It is up to the obligee which criteria he will be going to qualify whether he will suffer based on the principal total cost or the part which is written under the contract

What is Performance Bond Cost or Cost of Performance Bond

Performance Bond Cost (PBC) represents the bond cost that is levied on contract type and credit records of contractors. Every contractor has a different financial background and financial past credit performance by which cost is decided. Along with financial credit performance, the qualification of contractors does matter to evaluate a final rate of performance bond and contractors can’t take a step back from the contract. Suppose, high qualification and having a good past credit value contractor will low rate of performance bond due to never had been a bankrupt but on the other hand, low qualified and having poor past credit value contractor will pay a high rate of performance bond due to has been a bankrupt or insolvency in the business operations.

Additional fees are charged along with costs by the agencies who provide these contracts through the project owners and charge commissions on selling each project by the project owner. The commissions are paid when accepting a performance bond. Now you can understand, how qualification and financial value do matter for contractors to take a job contract from the owner to reduce the owner’s financial risk

How to determine the Performance Bond Cost

You don’t need to do extra calculations to determine a performance bond cost, you just go with the fixed rate of PBC that is levied based on contract type and contract amount or bond amount. Only 1% – 4% rate is charged based on the contractor’s amount. The rate of PBC is fixed based on such as:

  • Contractor’s financial credit value
  • Contractor type
  • Contractor amount
  • Past performance
  • Contractor’s goodwill and workability of work
  • Job Location or Industry type
  • Quality service
  • Additional fees charged by agencies, agents, or brokers

After identifying these requirements, surety agencies or brokers are decided what rate will be charged on Performance Bond Cost such as:

Less than a 1% rate of the contract amount will be charged for solvency contractors who have good financial credit performance.

More than 1% but less than 2% rate of the contract amount will be charged for fair contractors who have fair financial credit performance.

More than a 2% rate of the contract amount will be charged for good contractors who have poor financial credit performance.

As you can see, the rate depends on financial credit performance because past credit performance with qualification matters to fix job value such as bad credit history serves high rate on Performance Bond Cost, good credit history serves low rate on PBC

How performance bond acts

After knowing the cost evaluation on what basis, now you need to know why the performance bond is to be done? A performance bond is done to cover all obligations after meeting all the requirements while performing the contractor activities. If contractors have failed to perform with requirements due to any reason such as over-burden work, budget issue, lack of employees so they can be affected by the claim for late against the performance bond and will be paid to the obligee if the claim is valid. And after that, the principal becomes a payer for submitting the amount with interest along with additional fees that are charged by the Agencies or brokers.

Various kinds of cost that involve the activity of performance bonds and you can’t compare that costs with basic operating cost as well as other business costs, it can be a premium cost that makes a payback amount heavy or a burden.

Where performance bond has a big role

Performance Bonds have a big role in various industries but we will discuss three kinds of contracts where performance bonds play a vital and concerned role in which the contractor can’t make any single mistake, otherwise, they can bear a huge loss such as a PB amount. 

These are three kinds of contracts

  • Construction Contract
  • Real estate 
  • Commodities

Performance Bond in Construction contract

As we said above, Performance Bonds have a major role in construction contracts but let’s discuss the Construction industry, which is a well-known industry, which has the greatest danger risk, especially for the workers who are performing their activities on construction sites. But the issue is not a risk, the issue is what is the role of performance bonds with that risk.

Generally, project owners hire a professional contractor that can fulfill their work on time with positive efforts without investing extra time and cost, and for this, contractors get paid but a contract is made in between them if contractors (Principal) will not be able to perform their activities with a clear law, rules, and policies provided by the project owner (Obligee) so they have to bear a huge amount which also known as a bond amount that can include fees along with interest.

Now, you are thinking why do we need to pay interest with fees? Yes, we need to pay fees with interest because the surety owner which can be a bank will pay a 1% – 4% rate of the amount to the project owner(Obligee) to couldn’t be fulfilled to meet actual expectations for their work and after that surety owner goes towards to the contractors for paying a full amount with fees along with interest which is called a reimbursement.

Performance Bond in Real estate contract

Performance Bond also plays a role in real estate contract that is totally same as a construction contract, in which also contractors need to follow the project owner’s terms and conditions to meet contract obligations and build their performance bound for future and like as a construction contract if they can’t meet to fulfill contract obligations without breaking rules and policies understood by the project owner so they have to pay all amount to the contract with the support of surety owner. The rate of percentage is the same for contractors according to their performance value.

Performance Bond in Commodities Contract

The concept of commodities contracts is a little different from other contracts due to different dealings and reasons for the failure of projects. Suppose you are a buyer and you have given an order to a company seller for some goods but due to some serious reasons, a seller couldn’t successfully reach commodities to the buyer’s point. So in that case, the buyer needs to ask for a performance bond from the seller in advance so that if such a situation happens then the buyer will be able to claim compensation for recovering. Reasons for failure projects such as commodities not being delivered on time due to late manufacturing, defective commodities, and many other reasons.

End Points

  • A performance Bond is a security card for the project owners, which can be used by them at a time of failed projects. 
  • A PB is required by the project owner for future circumstances.
  • Contract jobs can be offered by the public as well as private companies.
  • A surety bond also plays a crucial role that supports contractors to recover losses ASAP at one time.
  • A PB also helps to decide the rate that should be charged on failure projects.

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