What is a Performance Bond?

A performance bond (or contract bond) is a guaranty issued by a third-party guarantor (also known as a surety) to one party to a service contract. The guarantor assumes financial responsibility for the service provider's failure to meet specific contractual obligations. The guarantor is most often a bank or an insurance company that ensures that a contractor fulfills the obligations of the projects assigned to him.

How does a Performance Bond Work?

Performance bonds are extremely common in the construction industry. Contractors bid construction jobs. If awarded the contract, the contractor may be required to secure a performance bond. The bond protects the firm requesting services from losses if the contractor fails to perform as agreed. As such, if a contractor fails to perform, the guarantor will be required to pay a sum of money (the "penal sum") representing the losses incurred by the party employing the contractor. The terms of the bond generally place a monetary limit or cap on the guarantor's liability. The concept of modern-day performance bonds materialized with the passing of the Miller Act. This act mandated the placement of such sureties in all public project contracts worth $100,000 and above. In commercial construction projects, performance bonds are secured in combination with payment bonds. Payment bonds guarantee that all entities associated with project work, such as subcontractors, construction workers and suppliers are paid in full after the completion of the project. This protects against subcontractors who are not paid filing a workman's lien or materialman's lien against the property.

Cost of Performance Bonds 

By convention, for contracts valued under $1 million, performance bonds costs are typically in the range of 1% to 2% of the total project cost. For projects over $1 million, performance bonds costs generally do not exceed 1% of the total value of the contract. The credit-worthiness of the contractor also plays an important role in determining performance bond costs.

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