Owners, developers, and contractors reach for two tools when a contract demands financial assurance: a surety bond issued through a bonding company, or a bank letter of credit. Both promise performance or payment if the contractor falters, and both can unlock a deal that might otherwise stall. But they work differently, draw on different reserves of a contractor’s balance sheet, and behave very differently if a claim lands. Choosing between them is not a generic finance question, it is a risk allocation decision with consequences for cash flow, relationships, and even future bidding capacity.
What these instruments really are
A bank letter of credit is a bank’s promise to pay a beneficiary upon a conforming draw. It is a direct credit instrument, typically treated as a contingent liability that ties up the Visit this page applicant’s borrowing capacity. A standby letter of credit is the common form in construction, typically tied to performance or payment obligations and often callable on presentation of specific documents. In practice, many standby LOCs are payable on demand if the beneficiary asserts default and provides prescribed paperwork.
A surety bond is different. A bonding company issues the bond as a three-party instrument. The owner or obligee is protected, the contractor is the principal, and the surety stands behind the contractor’s obligations. Sureties are not banks; they are specialized insurance companies that underwrite performance risk, monitor contractors’ financial health, and offer remedies that go beyond writing a check. The surety’s obligation is secondary, not primary, and it only responds after a bona fide default under the contract and the bond.
The distinction between primary and secondary obligation is not wordplay. It shapes how fast money moves, how disputes get resolved, and whether the contractor can keep working while issues are sorted out.
How the money is tied up
When you secure a bank letter of credit, the bank usually sets aside an equivalent slice of your credit facility. If you have a 10 million dollar revolver, a 2 million LOC reduces available borrowing by about 2 million. If the bank requires collateral, you may have to cash-secure all or part of the LOC. Even if not cash-secured, the contingent obligation sits on your balance sheet and counts against leverage covenants. In tight markets, that reduction can delay payroll, equipment purchases, or mobilization for another project.
A surety bond, by contrast, does not sit on the line of credit. It is an off-balance-sheet instrument in most cases. The premium is an expense, not collateral, and the bonding company evaluates your capacity across your backlog rather than against a single credit cap. That means you may be able to keep your bank facility for operations. The flip side is underwriting discipline. The surety’s engineers and accountants will scrutinize work-in-progress schedules, cost-to-complete forecasts, and job-level margins. If they are not comfortable, the capacity you thought you had evaporates.
For small contractors, the premium on a performance and payment bond might run from 0.5 to 3 percent of the contract value, depending on size, risk, and history. On large, clean, repeat work, premiums can land at the low end. Bank LOC fees vary, often between 0.5 and 2 percent annually, plus administrative fees, and drawdown interest if funding occurs. On paper, the LOC may look cheaper. After you factor the cost of tied-up borrowing capacity, especially during a growth phase, the picture can flip.
Claims and the speed of pain
The day a project runs into trouble is the day these instruments diverge. With a letter of credit, the beneficiary presents the specified documents. If they match the letter’s conditions, the bank pays. The bank does not arbitrate the underlying dispute. If the owner asserts default and follows the checklist, funds move. The contractor is left to litigate later and to reimburse the bank, often immediately. If the LOC is cash-secured, the cash leaves your account with no debate.
With a bond, the surety performs an investigation. The obligee must declare default and satisfy the bond’s notice terms. The surety assesses whether the contractor is actually in default under the bonded contract. That process can take days or weeks depending on complexity. Owners sometimes find the surety’s pace frustrating. Contractors often find it life-saving, because the surety may conclude the contractor has a viable plan to cure. The surety has options: finance the contractor to finish, arrange a replacement contractor, tender a completion contractor for the owner’s approval, or pay the penal sum. The best option varies with the stage of work, the reason for failure, and the claims environment.
There is a human dimension, too. Surety claims people tend to know the local market. I have watched a surety call a seasoned superintendent out of retirement to stabilize a job, keeping a team intact while procurement issues were fixed. A bank cannot do that; it wires funds and steps aside.
The cost question, properly framed
The headline numbers can mislead. A 1 percent fee for a 5 million dollar LOC feels smaller than a 2 percent bond premium on the same project. Yet the LOC fee is annual. If the project runs 18 months, you pay 1.5 percent plus the lost capacity on your line for that period. The bond premium is typically paid once per term, even if the project lingers, though some sureties charge continuation premiums on multi-year obligations. If the surety requires collateral due to risk, the economics change again. If a bank requires full cash collateral, the LOC becomes an expensive certificate that locks up precious liquidity.
When I help contractors model this, we build two cases: the arithmetic cost, and the opportunity cost. The arithmetic is simple fees. The opportunity cost considers whether tying up borrowing capacity will force equipment rentals at higher rates, foreclose an early pay discount on materials, or push out a higher-margin job you cannot bid while capital is constrained. In several cases, the “cheaper” LOC cost more in the aggregate once those second-order effects were counted.
Control, relationships, and reputations
Owners sometimes prefer letters of credit because they seem cleaner. If things go wrong, a draw is straightforward. That sense of control is real, but it comes with responsibility. Because the bank does not police the underlying contract, wrongful draws can spiral into litigation and reputational trouble. Sophisticated owners draft tight draw conditions to avoid disputes and to preserve leverage without inviting abuse.
Surety relationships are different. A bonding company is a long-term partner for a contractor. They see financials quarterly, track backlog, and understand risk habits. In return, they will go to bat for a contractor who stumbles for fixable reasons, like a mis-sequenced schedule or a late supplier. Owners who understand surety mechanics can leverage that. A call with the surety before declaring default often surfaces a workable path that preserves time and money.
On public work in North America, owners often have no choice. Statutes in many jurisdictions require performance and payment bonds for contracts above a threshold. In private development, the owner gets to choose. Some owners prefer a letter of credit because they have had a bad bond claim experience where the surety moved slowly. Others prefer surety because a bank LOC can be drawn prematurely by a nervous lender upstream, upsetting a project over a short-term cash kink.
Impact on subcontractors and suppliers
Payment assurance downstream matters. Payment bonds, paired with performance bonds, protect subs and suppliers who might otherwise file liens. A letter of credit does not filter down by default. If an owner draws on an LOC, there is no automatic mechanism to channel funds to subs. The owner might use the funds to pay a completion contractor or to cover delay damages. That can leave unpaid parties in limbo.
On projects with a deep and specialized subcontractor bench, a payment bond can be the difference between a quick recovery and a mass exodus. I have seen electrical suppliers keep shipping material in a troubled period because they trusted the payment bond, even while the GC sorted out a disputed change order. Without that backstop, the supply chain can freeze at the worst moment.
Documentation and hidden friction
The gloss of simplicity hides friction points. LOCs live or die by their documentary conditions. Ambiguity in those conditions is a breeding ground for disputes at exactly the moment you need clarity. Banks draft LOCs tightly to reduce risk, and beneficiaries push for broad draw rights. Negotiations can drag, particularly in cross-border projects where local legal standards for “independence” of the credit differ. If the LOC is confirmed by a second bank to reduce country risk, you add another layer of fees and conditions.
Surety bonds are standardized in many markets, but not uniform. The AIA, EJCDC, and ConsensusDocs forms have differences in notice requirements and remedy options. Public owners sometimes issue their own bond forms that expand the surety’s obligations or compress cure periods. If your bond rider accepts those terms without pricing the added risk, you may be surprised when a claim tests those provisions. The time to negotiate both instruments is early, not when mobilization is days away.
Creditworthiness and access
A clean, well-capitalized contractor can often get both. The constraints show up when a firm is growing fast, has a thin equity base, or is coming off a rough year. Banks look at financial ratios and collateral. Sureties look at working capital, net worth, experience, and the pattern of risk in the backlog. They also consider management’s judgment. If your WIP reports show chronic underbilling and late recognition of losses, the bonding company will take a conservative stance.
For a contractor with limited bank capacity but solid execution history, the surety market can be more forgiving. For a contractor with strong collateral but scattered project controls, a bank LOC may be easier to obtain. Start-ups face an uphill climb with both. Many start with small bonded jobs, build a track record, and expand capacity over time. Personal indemnity is standard in surety. Owners often dislike giving it, but without it, bond capacity shrinks or disappears.
Remedies when things break
Bank LOCs are binary. The beneficiary draws, the bank pays, and the applicant reimburses. If the applicant cannot reimburse, the bank may liquidate collateral, call defaults, and cascade issues across the company’s credit stack. That can topple a contractor who might have otherwise finished the project with a bridge of time and management support.
Sureties are problem solvers by design. The best outcomes emerge when the contractor calls the bonding company early, before a formal default. If the surety believes a job is salvageable, it can lend support that would be hard to obtain from a bank under stress. That can include arranging for specialized advisors, fronting funds under a bailout agreement secured by contract balances, or negotiating schedule relief with the owner while work continues. When a surety decides a principal is incorrigible, the process can be painful. Replacement contractors charge a premium, and the surety will pursue the contractor and its indemnitors for losses. Still, the set of options is broader than in the LOC world.
International and sector-specific wrinkles
Cross-border projects shift the calculus. In some countries, owners and lenders favor on-demand bank guarantees or letters of credit because local enforcement of bonds is slow or uncertain. Confirmation by a reputable bank can comfort an owner who doubts the applicant’s home bank. In energy or process sectors where defects can trigger large consequential losses, owners may stack instruments: a performance bond for completion, an LOC for warranty obligations, and parent company guarantees for added comfort. Each layer adds cost, but each may target a distinct risk.
In private industrial projects, owners sometimes accept a letter of credit because their EPC contract allocates liquidated damages clearly and they prize fast access to cash over the surety’s cure options. In vertical commercial building with lots of subcontractors, payment bonds are often non-negotiable to keep the trades engaged.
Negotiation strategies that reduce regret
Small drafting choices change outcomes. If you are an owner leaning toward an LOC, define draw conditions precisely. Tie draws to objective triggers, such as failure to meet a certified milestone Axcess Surety after a cure notice, or a third-party engineer’s certification. For cross-border LOCs, consider confirmation and choose a governing set of UCP rules that your team understands. Make sure expiration and automatic extension terms align with real project schedules.
If you prefer a bond, push for a form that balances speed with fairness. Extended notice and cure periods sound generous, but too much slack can leave you without leverage when momentum is needed. Keep the penal sum appropriate to the risk. A 100 percent performance bond is common for public work, but on private projects, graduated bonding that starts lower and steps up as work progresses can make premiums more rational.
On the contractor side, treat the bonding company as part of your strategic finance plan. Keep them current on WIP, be transparent on problem jobs, and avoid surprises. The day you need them to increase capacity for a must-win pursuit is not the day to reveal an unbooked loss residue from last quarter. For LOCs, negotiate headroom in your revolver for contingent obligations before you need it. Some banks will carve out a sublimit for LOCs that does not pinch the operating line as tightly, especially if cash flows are strong and covenant compliance is reliable.
When a hybrid makes sense
There are times when the right answer is both. I have seen owners accept a performance bond for completion risk, and a small letter of credit dedicated to warranty obligations or early equipment advances. The bond handled the complex risk of finishing the job, while the LOC gave the owner quick recourse for a discrete exposure. On a wind farm project, the turbine supplier required an advance payment guarantee via LOC, while the EPC contract required performance and payment bonds. The contractor treated each instrument as a tool, not a statement of philosophy, and the finance plan made room for both.
Another hybrid approach is phased security. Early in the job, when mobilization and design coordination dominate, a lower penal sum bond or a small LOC may suffice. As steel goes up and cash flow spikes, the instruments step up accordingly. This requires careful contract drafting and a visibility into schedule that many teams do not maintain. Where it can be done, it matches cost to risk more closely than a blunt 100 percent instrument from day one.
Risk culture and the people factor
No instrument substitutes for governance. I have seen well-bonded projects fail because the owner allowed scope creep to swamp the schedule, then tried to push that pressure onto the bond with predictably messy results. I have also seen LOC-backed projects sail smoothly because the parties had crisp change control, frequent cost-to-complete updates, and a shared understanding of what would trigger a draw.
The bonding company you choose matters. Two sureties can read the same financials and make different calls because one truly understands your niche and the other does not. For specialty work, such as complex mechanical systems or heavy civil with variable geotechnical risk, choose a bonding company that employs engineers who have actually built something similar. The bond is only as good as the surety’s willingness to engage early and intelligently.
Banks differ, too. A relationship bank that knows your seasonal cash swings will structure an LOC facility that does not choke you at the worst moment. A transactional bank may grant the LOC but impose covenants that turn a routine hiccup into a default.
Practical decision frame
If you have to choose quickly, focus on four questions:
- What risk are we actually trying to protect against, and who can mitigate it better: a bank’s immediate liquidity or a bonding company’s completion expertise? How scarce is our borrowing capacity over the life of this project and the next two in the pipeline? How will a claim likely unfold on this specific project, with these stakeholders, in this legal environment? Which instrument will keep the supply chain most confident and the project team most focused if things wobble?
A clean, high-trust owner-contractor relationship with a strong track record may function well with either. A complex project with many trades, a tight labor market, and a demanding schedule usually benefits from the surety’s toolkit, despite the potential for slower payouts, because it preserves continuity. A simple, milestone-driven scope where liquidated damages are the main fear may lean toward an LOC, especially when the owner must demonstrate immediate recourse to lenders.
The bottom line on pros and cons
The letter of credit is simple in appearance, fast to draw, and blunt. It consumes bank capacity and can trigger cascading credit issues if called. It does not solve problems; it funds them after the fact. It is best when the beneficiary values liquidity over process and the risk is quantifiable and narrow.
The surety bond is more complex, slower to liquidate, and often cheaper in true economic terms. It preserves bank lines and injects a partner who can help finish the work. It requires trust, openness with the bonding company, and some tolerance for process. It is best when continuity of work, protection of subs and suppliers, and completion certainty matter more than instant cash.
In practice, owners and contractors who treat these instruments as part of a broader risk plan, not a checkbox, get better outcomes. They negotiate the right form, size the instrument to the risk, and maintain relationships with both their bank and their bonding company. When the day comes that something breaks, those relationships, not the paper alone, determine whether a project limps to the finish or gets back on its feet with minimal scars.