Many people mistakenly believe that a bond and bank letter of credit are the same thing. There are several differences in how they are obtained and what they are designed to do. The primary difference between the two is a bond guarantees work will be performed, while a letter of credit promises that payments will be made. Understanding the difference can help you know what to ask for when the time comes.
Payment Versus Performance
A letter of credit promises to cover payments for a project, up to the stated credit amount, on an approved project. For example, if a developer is building a subdivision and needs to purchase supplies, the letter of credit guarantees the supplies will be paid for. The supplier only has to show invoices and proof of delivery or pick-up to the bank and the bank will cut a check to pay for them. A bond puts up a specified amount of money to ensure contractual work will be performed to the contract standards. If the work is not completed, or is substandard when compared to the contract terms, the recipient can request bond funding be released to hire someone to satisfactorily complete the work.
The cost for a letter of credit averages 1 percent of the total value of the contract. A bond costs 0.5 to 2 percent of that same value. Another significant difference between the two is that a letter of credit holds the funds which can temporarily reduce the recipient's net worth and cash flow abilities. A bond does not tie up any actual funds, but pays out if needed at the end of the contract.
A bond is typically issued through an insurance surety company. In the case of a government agency, such as a city or county, the bond may be issued directly from the government coffers. Banks or other lending institutions such as credit unions are responsible for issuing letters of credit. How much the letter of credit is for depends on several things including the credit scores, number of projects and prior relationship of the requester with the bank.
Both a bond and a letter of credit depend on the recipient's past track record with getting work done and paying the bills. If a recipient develops a reputation for not completing work that was contracted, he will have a difficult time getting a future bond. If he does not pay the bank for supplies and other costs of a project, banks will begin to refuse to give him letters of credit for future projects. Though they work in different ways and are issued by different bodies, they both base their future decisions on past performance.
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