If you own a small business, you've certainly heard of the impact that a single missed payment or unfulfilled obligation can have on your business.
Hopefully, you haven’t experienced this first hand. To protect yourself and your customers, you can use surety bonds or letters of credit to manage these risks.
While there are similarities between surety bonds and letters of credit (also known as ILOCs or Irrevocable Line of Credit), there are significant differences between them. Both can be used as a risk management system, but only one of them can save you money.
What is a Surety Bond?
A surety bond is a three-party agreement between a principal, an obligee, and a surety.
- Principal: the one who needs the bond
- Obligee: the one who is protected by the bond
- Surety: the one who issues the bond
In short, a surety bond is a contract that guarantees you will fulfill your tasks and obligations.
The exact specifics your surety bond guarantees is dependent upon on the type of surety bond you secure.
If you fail to fulfill your obligations, someone can make a claim against your bond.
Unlike insurance claims (where you do not have to repay the insurance company), if a surety company pays out on a bond claim, you are responsible for repaying the surety company every penny.
What is a Letter of Credit?
A letter of credit is also a three-party agreement, but between a beneficiary, a buyer, and a bank.
- Beneficiary: the one who will be paid
- Buyer: the one who buys the goods or services
- Bank: the one who issues the letter of credit
In short, a letter of credit is a cash guarantee that a beneficiary will be paid for the goods or services provided to buyers.
How letters of credits work is that when a letter of credit is created, the bank freezes the buyer’s liquid assets in the total amount of the letter of credit.
The buyer is not able to access these funds until the bank releases the letter of credit.
If a buyer does not pay for the goods or services provided to the beneficiary, the beneficiary is able to use the letter of credit to access the funds that the bank has held in the letter of credit.
Surety Bond Vs Letter of Credit
Difference #1: Claims
Surety bond claim:
When a claim is made against a surety bond, the surety company must investigate the claim to determine if it is valid. The surety company will only pay out on a claim if the investigation deems the claim valid.
The surety company does not want to pay out on a claim, so they will most likely investigate other options, like arranging for another individual to complete the job.
There is low risk of false claims with surety bonds because all claims are investigated thoroughly.
Letter of credit claim:
When a claim is made on a letter of credit, banks need only verify receipt and correctness of documentation required of the letter of credit before paying the beneficiary.
The bank will pay on a letter of credit upon demand, as long as the demand is made prior to the letter of credit’s expiration date.
In this sense, there is a fraud risk involved in letters of credit, in which letters of credit can be obtained through falsified information or forged documents for worthless or nonexistent goods or services.
Difference #2: Cost
Cost of surety bonds:
If you need a $50,000 bond, you do not need to pay $50,000. You will only pay a small percentage of this amount.
Generally, you will pay anywhere from 1-15% of the total bond amount.
If you have good credit, you might only pay 1-3% of the bond amount.
A $50,000 bond with good credit might only cost you $500.
The best way to see what you would pay for a surety bond is to get a free quote:
Cost of letters of credit:
You also do not need to pay the entire letter of credit amount to get a letter of credit.
Letters of credit normally cost 1% of the amount covered in the contract.
For example, if a buyer needs a $100,000 letter of credit and the letter of credit will cover 10% of the contract ($10,000) then the buyer will pay $100 for the letter of credit.
Surety bond rates might may appear to be higher than the rate for a letter of credit, but in the long-run surety bonds are less expensive and can help you save money.
Letters of credit freeze cash assets for the entire amount of the letter of credit. Individuals who purchase surety bonds can experience much more liquidity with their assets and can save money in the long run by being able to invest in their capital that is available to them.
Letters of credit also can require full collateral in addition to the cost of the letter of credit.
Advantages of a Surety Bond
- Credit capacity: A letter of credit ties up a company’s credit capacity, thus reducing its financial flexibility. Surety bonds are not credited against a company’s bank line.
- Covenants: Banks can place restrictive covenants on the client in return for extending a line of credit. Surety companies typically offer more flexibility when it comes to bonds.
- Security: Banks can choose to take a security interest in the client’s assets. A surety is generally an unsecured creditor. Rarely will you have to make a security filing with a surety bond.
- Default defense: A letter of credit may be drawn down at any time; the company has no defenses. With a surety bond, the surety request proof of a default and thoroughly investigates the default before deeming it valid.
- Claim handling: Banks often do not have a claims staff, so the client is left to resolve disputes on his/her own. Surety companies normally have a reliable claims staff that handles disputes and assist in the claim process.
- Rates: Letters of credit often come with hidden fees such as commitment fees, utilization fees, or issuance fees, which can skyrocket the rate of issuing a letter of credit. Surety rates tend to remain stable and hidden fees are rare.
When to use a Surety Bond Over a Letter of Credit
Parker Smith and Feek gives great examples for when a surety bond makes more sense than a letter of credit:
- Surety rates may be less than what a bank is charging, which often includes fees.
- A bond frees up cash providing a better working capital position as well as creating additional borrowing capacity.
- The Beneficiary of a Letter of Credit may go straight to the bank and demand payment within 72 hours. With a bond, in almost all cases, a claim has to be made to the Surety and an investigation ensues to find out if the Principal failed to perform the obligation of which the bond was provided.
- Typically bonds are not noted in the financial statements as contingent liabilities where Letters of Credit are included.
- A Letter of Credit may be held for up to two years before it is released by the beneficiary – especially if there is a warranty involved.
The Right Choice for your Business
For individuals who qualify, surety bonds are most often the best choice for many reasons. In the long run, they usually end up being cheaper than letters of credit, they don’t require collateral (on most occasions), and they allow applicants more flexibility with their assets.
Choosing between a surety bond and a letter of credit can be a hard decision to make, but if applicants can look beyond the initial rate/price, a more uniform and whole decision can be made—one which can benefit a business more than the other.
If you are a small business owner and you have decided that getting a surety bond is the best route for you, choosing the right surety bond company is the next step you need to take to get bonded.