Often when you're applying for an occupational license you may be given the option of getting a surety bond or a letter of credit from a bank.
Both serve the purpose of ensuring you perform your job duties according to the law and service your customers without committing financial fraud against them.
The major differences between a surety bond and letter of credit lie in:
- How each is "purchased"
- How each may or may not pay out to a harmed party
- And how the "issuing" party will protect you
This short article will explain these differences so you know if purchasing a surety bond or letter of credit is the right decision for you.
Purchasing a Surety Bond vs Letter of Credit?
What is a Surety Bond?
A surety bond is a type of insurance contractor guaranteeing your performance. They're required in a lot of difference occupations and circumstances, the most common being:
- Contractor license bonds
- Vehicle title bonds
- Motor vehicle dealership bonds
- Mortgage broker bonds
- Business services bonds
A surety bond will go to an underwriting process with a surety. A surety is an insurance company that underwrites the type of surety bond you need.
There are many types of surety bonds depending on your specific license.
Your bond will have an amount of coverage, this is the same amount you would have to obtain a letter of credit if you choose that option.
This amount is the maximum financial protection afforded to the customers you service.
The price of a surety bond typically ranges from 1% to 3% of the bond amount.
Bond amounts can range from $5,000 to hundreds of thousands of dollars, even millions, depending on the bond type and function.
When you purchase your bond, it has a bond term of one year, maybe more depending on the bond.
What is a Letter of Credit
A letter of credit a set amount of available funds guaranteeing the performance, the same as a surety bond.
A letter of credit is obtained from a bank. The bank is extending their credit and guaranteeing the balance of money. This balance would be the same amount as the surety bond amount.
When you get a letter of credit your personal credit will likely always be a factor.
And you will likely have to put a deposit amount close to 100% of the amount if you don't have excellent credit.
The First Major Difference Between a Surety Bond vs a Letter of Credit:
Purchasing a surety bond is often easier and cheaper.
The reason for this is insurance companies do this for a living to they understand the different markets and associated risks and can offer far better terms.
On average we can help business owners and individuals obtain the surety bond they need with no credit check. And what's more, we help offer download of your surety bond immediately after you purchase.
Offering letters of credit is not the banks primary business purpose so they will require more security to fulfill the promise.
Unless you and other owners of your business have exceptional credit, a surety bond will be far more affordable.
Maintaining a Surety Bond vs Letter of Credit
As mentioned, when you obtain a letter of credit you will likely have to put down 50% to 100% of the money in the account.
This money will stay there as long as you're in business, providing that guarantee of performance, so your money is never available to use for business investment.
A surety bond requires you pay a premium and will need to be renewed, typically on a 12 month basis.
The Second Major Difference Between a Surety Bond vs Letter of Credit:
Maintaining a surety bond is far less expensive because it will only be a payment of 1% to 3% of your bond amount every 12 months.
Some surety bonds can be purchased for multiple years.
The letter of credit is typically a large lump sum capital outlay that binds those funds for as long as you stay in business.
So while there is no yearly payments, you've already tied up a large sum of money.
It would take years if ever that your bond renewal price would ever equal the full bond amount required.
Receiving Claims for a Surety Bond vs Letter of Credit
A claim would be filed if a customer ever thought you purposefully committed fraud against them that costs them money either directly or indirectly.
In the event of a claim, an investigation would take place to make sure the claim is valid. Not all claims are valid examples of fraud. And in many cases these disagreements can be remedied directly between the two parties.
But this is not always the case and claims do happen every year.
The Third Major Difference Between a Surety Bond vs a Letter of Credit:
When a claim is made, both the bank and surety (insurance company) will thoroughly investigate to make sure the claim is not frivolous.
In the case of the bank, again this is not their primary business so it's likely the bank may pay the claim to avoid unnecessary legal actions.
The surety on the other hand has a dedicated claims adjustment department who's job is to investigate claims. This is their primary business and they know how to determine if a claim is valid or not.
When you purchase a surety bond, you're also getting an insurance companies claim investigation department at your back.
Should You Choose a Surety Bond or a Letter of Credit?
If you have excellent credit and the amount required is low enough, the letter of credit is likely to be the better option. In the right circumstances, the bank will require no money to be put up by your business.
In this ideal circumstance you can, you can avoid yearly costs as well.
However, if you have good to poor or limited credit, or if the amount required is a large, the surety bond will likely save you considerable money not only initially but over the course of your business life.
You can learn more about how a surety bond costs and how long it takes to have a surety bond issued. When you're ready to get your surety bond, you need to make sure you find the correct bond type.
Click here to use our bond search if you know the type of surety bond you need.
If you're not sure your exact bond type, click here and use our surety bond finder quiz.
You can also call a bond specialist today who can help you over the phone at 1-800-608-9950.
