What is a Surety Bond?
A surety bond is issued by a third party as a guarantee that a second party will fulfill a financial obligation. It sounds complicated, but the idea is simple. If your lender wants a guarantee you will pay back your loan, you can have your bank issue a surety bond to vouch for your ability to do so. This is a simple model, and most surety bonding actually occurs at the institutional level rather than with private investors. There are three parties involved in all cases, and each fulfills a certain role.
The principal is the party seeking the contract. Think of this person or group as the borrower who wants to set up a contract in order to receive a benefit, usually financing. The Principal agrees to certain terms of repayment, typically with interest. The Principal's personal guarantee is not enough, so they must go to a second source. This second source will vouch for the Principal.
The Obligee is like the lender. This party is the one extending the service, usually financing, to the Principal. The Obligee needs a more credible source than the Principal alone to sign a contract with. Because of this, the Obligee asks for the Principal's agreement to be bonded with a third party. This is where the Surety comes in. Many contracts will guarantee a time limit for a project to be finished, like a building project.
The Surety is usually a large, rated institution. Being rated by Standard & Poor's, or Moody's, shows the Obligee that the Surety is in good financial health. The Surety may be a bank, but it is just as often an insurance company who agrees to assume the risk. The Surety receives a payment from the Principal in exchange for this service. The payment is usually a commission of the total amount bonded. However, if the Principal defaults on the agreement, the Surety must pay. There is a total penal sum determined at the beginning of the agreement. This is the highest amount a Surety will pay.
If you are seeking funding for a real estate project, you may locate a source who wants a more secure situation than you can offer. This source, the Obligee, says they will extend financing if you can guarantee the project will be completed within 3 years and all debts will be returned in 10. You, the Principal, agree to these terms. Then, you approach your insurance company, the Surety, to have it bonded. The insurance company agrees, bonds the deal, and you now have your business loan. You pay interest on the loan and pay a fee to the insurance company.
A new program provided by the SBA
The Small Business Administration now offers a surety bond guarantee option. If you are a small business owner seeking financing and need surety bonding, you can consider getting your business loan guarantee through the SBA. You will likely save money over traditional insurance companies as the SBA offers large incentives to business owners.