Comparing surety bonds to irrevocable letters of credit

Often times, the law of the local, state or federal government may require a company or individual to provide “insurance” that they will abide by the laws of their profession, or by the terms of their contract. The first misleading aspect of this “insurance” is that it is not insurance at all. Many people think of auto insurance or health insurance as examples; where an individual (the principal) pays a premium to an insurance company to be covered. When a claim is made, the principal receive a payout from the insurance company. This two party system is not what the government is looking for.Instead the contractor or business owner has two choices: either to obtain an irrevocable letter of credit from the bank or to apply for a surety bond that pertains to there area of work. Which is the best option for you? Let’s take a closer look at the differences and similarities of the two.Irrevocable Letter of CreditFirst is the irrevocable letter of credit, or ILOC. By choosing to obtain an ILOC you are receiving a letter from the bank that essentially is saying that you are “good for” a particular amount of money (this amount varies depending on why the project or government, otherwise known as the obligee, is requiring you to apply for this). This letter of credit is held by the obligee (the person or entity requiring this protection). In the event of a claim, the obligee can draw on these funds held by the irrevocable letter of credit.The catch of the ILOC is that the bank usually “freezes” the full amount of ILOC in cash. For example if you are required to have an ILOC for $100,000, then the full $100,000 will be held by the bank and inaccessible to you.Surety BondsA surety bond is a three party agreement involving a principal (the party obtaining the bond), an obligee (the party requiring the bond of the principal), and a surety (the entity who is backing the bond). In the event of a claim, the surety pays out to the obligee. In short you, as the principal, are using the financials of the surety to cover you, while only having to pay premium on the bond (in some high risk/bad credit cases some collateral may be required).It should be noted that a surety bond is a form of credit and not insurance. Should a claim occur, the surety will look to the principal for repayment of the claim.Which is right for you?Though at first glance it may appear that Surety Bonds are more expensive, while still requiring you to pay for a claim, this may not be completely true. Let’s take a look with some simple math. For simplicity, let’s continue to use our $100,000 example.An ILOC generally costs 1 (the banks charge) a year, or $1,000 for the $100,000 letter.Generally a Surety Bond will fall in the 1-3 range (depending on credit), or $1,000-3,000 in our example.Yes simple math seems to prove that Surety bonds are more expensive, but let’s now look at the real costs. First and foremost with the ILOC in our hypothetical situation above, the $100,000 is locked up by the bank, meaning they are earning interest of this money and not you, at the 3.5-4.5 money market average, you are leaving $3,500-4,500 on the table. On top of this lost income, you have no access to this money should another opportunity, or crisis, come you way. These points make the true cost of an ILOC almost incalculable.On the other hand, there are no hidden cost attached to a surety bond, and you are free to hold, invest, or use your money as you wish.If you qualify for a surety bond, it is clearly the better choice. It is cheaper, and leaves you and your business more flexibility for the future.

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