Many people dream of building a new house from scratch, but are often afraid. I can understand them. A homeowner usually knows how his house must look, but the entire construction process may seem like a nightmare.
The idea that you can trust a large sum of money to a contractor makes homeowners think of guarantees. In this context, financial management in the construction industry plays a critical role.
Moreover, both homeowners and contractors need some mechanisms to ensure financial documents are in place. A homeowner either appeals to banks for a performance bond for construction or applies a retainage.
In my blog article, I will discuss what a performance bond is in construction and how it impacts a general contractor’s work.
A performance bond is a guarantee that the contractor will complete the project according to the contract obligations. Basically, it is a promise backed by a third party, usually a bank or a surety company.
If I, as a contractor, cannot finish my work, the bond ensures the owner won’t lose money or have to start the project all over again.
These types of bonds are common on public projects. For example, if the project owner is the government in charge of building bridges or schools, large sums of money are at stake. Another case is big commercial projects, such as factories or office buildings, especially when the contractor is new to the client.
Performance Bond vs. Insurance
One may think that a performance bond in construction looks likeinsurance. However, there is a huge difference.
While insurance generally protects against risks, such as accidents or damages, a performance bond guarantees that the contractor will do the job they promised.
Besides, insurance is an agreement reached between two parties, while a performance bond is between three. The bond is about fulfilling the general contractor contract, not about covering risks or damages.
💡 For example, a contractor can have a general liability insurance against incidents at the site and at the same time a performance bond to guarantee the building will be finished in compliance with the contract.
How Performance Bond Works
Before learning the step-by-step process of getting a performance bond there are three parties involved:
Obligee (owner): A client for whom the general contractor is doing work.
Principal: A general contractor who is hired to run the project.
Surety Company: The third party that provides a bond ensuring the contractor’s performance.
If I am an owner of a project, I ask for a performance bond before any work begins. To get the bond, the contractor applies through a bank or surety company. By the way, in the U.S., there is a dedicated organization uniting surety bond producers – the National Association of Surety Bond Producers helps with finding the expert you need.
The surety will check the contractor’s financial stability, past performance, and ability to handle the job. The documents depend on the amount of the contract. For instance, for a bond exceeding $400,000 in California, the principal may be asked:
Balance sheet
Income statement
Cash flow statement
Complete notes and disclosures
Work schedules
Once approved, the contractor pays a small premium, and the bond is issued. Typically, a bond makes around 1%-3% of the total contract amount.
From that point on, the bond acts as a guarantee to me. If everything goes smoothly and the contractor finishes the work, I will just have it as a document in the background.
However, if the contractor fails to deliver for some reason, such as going bankrupt, I can file a claim against the bond.
Situations Where a Performance Bond Is Mandatory
It’s clear that a small custom home project most likely would not need a performance bond. However, there are clear situations when it’s not only strongly required but is mandatory by law.
Public Projects
In the United States, bonds are mandated by law for public projects. Under the federal Miller Act (1935), all federal construction projects valued over $100,000 must include performance bonds.
However, at the state level, there is a similar regulation for a smaller project. The so-called “Little Miller Acts” apply rules to state and local projects valued from $25,000 to $100,000. The purpose of these regulations is, first of all, to protect taxpayers’ money if something goes wrong with the contractor.
Specific Private Commercial Projects
Even though in some projects a performance bond is not mandatory, it’s a usual practice. In the private sector, it is applied in the case of high-value large projects or infrastructure projects, for example, schools and hospitals.
Additionally, owners, lenders, and investors want assurance that a major project won’t collapse financially if the contractor fails to fulfill obligations.
High-Risk Cases
There is another specific scenario when the owner may demand guarantees. It may occur when the owner is working with a contractor for the first time, and the project carries unusual risk.
The risks may be the following:
Working with new or unproven contractors
Projects involve complex technical requirements
Project values exceed $1 million
Expensive equipment and materials are used
Tight completion deadlines
Limited contractor financial information
Claims and Default Scenarios
When things go wrong and the contractor is not able to complete the project, a claim is made. There are many scenarios in which the contractor may default. There can be poor performance that leads to budgeting problems, some financial problems, or a builder decides to abandon the project for some reason.
When a valid claim is made, the surety company has several options.
Pay the Owner: The first and simplest solution is to pay. The surety can pay an owner a cash settlement up to the bond amount to cover the losses. The problem is that the payment may not fully cover the costs if they exceed the bond value. So, the surety either pays the bond limit or the amount needed to finish the project.
Hire a Replacement: The surety can also take over project management and hire another contractor to finish the work. By the way, in this case, surety can use existing materials and equipment.
Finance the Contractor: If a contractor who has not managed to fulfill obligations under the contract has temporary problems, the third party may provide financial assistance.
The surety often thoroughly investigates the claim before paying to verify the default and assess remaining work.
Performance Bonds vs. Retainage
When you first read about performance bonds, you might think they sound a lot like retainage. The purpose of both instruments is to protect the owner’s money and make sure the work gets done. However, the differences are pretty clear.
In the case of a performance bond, there is a third-party guarantee that the contractor will complete the project according to the contract. If a contractor fails, the payment comes to cover the losses or arrange for the project to be finished.
On the other hand, retainage is when the owner withholds a percentage of each payment until the project is completed.
Each approach has its pros and cons. A performance bond does not affect the contractor’s cash flow. However, it does come at a cost, typically a percentage of the contract price. Unlike this, retainage reduces the contractor’s cash flow as it is applied to each payment, and it’s especially challenging for small construction firms.
to each payment, and it’s especially challenging for small construction firms.
Comparison Point
Performance Bond
Retainage
How the Owner is Protected
Via Surety
Directly withheld from the contractor.
Risk Covered
Contractor default, non-completion
Poor quality of work, incomplete tasks.
Cash Flow
Contractor full progressive payments (except for bond premium)
Partially withheld until the project is completed.
Cost
Paid by contractor (typically 1%-3%)
No costs from the beginning of the project, but when applied, the cash flow is affected.
Types of Bonds
In addition to performance bonds, there are several other types. Let me show you the most common types.
Payment Bond
It ensures that subcontractors, suppliers, and laborers get paid for their work or materials on a project. Unlike a performance bond, which guarantees the contractor completes the project, a payment bond focuses on financial protection.
On public projects, these kinds of bonds are especially important to prevent disputes. This protection ensures everyone along the supply chain is compensated.
Performance Bond
Payment Bond
Owner protection
Protection of subs, laborers
It guarantees that the contractor will complete the project in compliance with the contract. If the contractor fails, the surety pays the owner or arranges completion.
It guarantees subcontractors and laborers will get paid for the work or materials they provide, even if the main contractor has financial difficulties.
Bid Bond
It comes during the bidding process for a construction project. A bid bond ensures that a contractor who wins the bid will formally sign the contract and secure the required performance and payment bonds.
Thus, the owner is protected against financial losses. The bid bond compensates the owner for the difference between the winning bid and the next lowest bid. It appears when the contractor refuses to sign the contract after winning. Bid bonds are usually a small percentage of the total bid.
Summing Up
Performance bonds are a risk management tool. They create a protection mechanism for owners who may suffer financial losses because a contractor fails to complete the task on time and according to the contract.
It’s clear that the larger a project is, the higher the stakes are. That’s why a performance bond is used in big projects, especially public ones involving taxpayers’ money. In fact, the bonding process serves as a valuable business health check.
Thus, the approach forces builders to maintain financial transparency and keep operations well-organized.
Are Performance Bonds the Same as Insurance?
Although both mechanisms are designed as protection mechanisms, insurance protects against risks, such as accidents or damage. Meanwhile, a performance bond guarantees that a project is completed as agreed by the contract.
How Much Does a Performance Bond Cost a Contractor?
In general, the cost of a performance bond ranges between 1% and 3% of the total contract value. The exact figures depend on the contractor’s credit history and the size of the project.
When Are Performance Bonds Mandatory?
Public projects require a performance bond in the U.S. under the Miller Act. In private projects, they are usually required when technical risks and the value of the project are high.
Who Benefits from a Performance Bond?
The project owner is the main beneficiary. Through a performance bond owner gains assurance that the contractors will fulfill their obligations. When it comes to a contractor, a performance bond builds trust with clients and improves credibility.
When people search for “whole home remodeling,” they usually already know small fixes won’t do the job. A bathroom update or new floors might help, but most probably the house needs a complete transformation. I’ve worked with clients who started with “we just want to redo the kitchen” and a month later admitted the whole […]
When can a general contractor call the business successful? I guess it’s when there is a stable cash flow and no problems with finding new projects. Without a flow of leads, even the best teams and the best proposals won’t keep projects coming in. Yet for many contractors, finding marketing ideas is a difficult task, […]
In the past few years, I’ve seen residential construction change faster than at any other time in my career. The pace of new project management tools and methods entering the field is no longer gradual. It’s constant, and it’s reshaping how homes are designed, built, and managed. What stands out to me is how residential […]
