Surety Bonds vs.

Irrevocable Letter of Credit

Ben Williams AFSB, CRIS
At some point most contractors will ask themselves whether they should post an irrevocable letter of
credit (ILOC) instead of a surety bond. Here we discuss the items a contractor should consider before
making a decision.
Cost
Although it should not be the most important decision, cost is certainly a determining factor. Surety
bonds can be priced in a variety of ways from a flat percentage to a sliding scale. Typically, pricing is
going to be in the range of 0.5%-3% of the contract price with the price decreasing as the contract get
larger. ILOC pricing depends on the bank and contractors credit but generally is going to be 1% of the
contract price that is covered by the ILOC. A typical contract might require that an ILOC in the amount of
10% of the contract price be posted. One potential cost downfall to the ILOC, however, is that they
might maintain an evergreen clause which may include additional fees. In other words, the ILOC might
be for a time period of 1 year that automatically renews annually as long as the project is still in
progress. They will typically charge another fee when this happens.
Advantage: ILOC

Financial Impact
For most contractors, this is the single most important consideration when making this decision. Bonds
are issued on the financial strength of the contractor and typically have no effect on the borrowing
capacity of a contractor. Although, the premium shows up as a business expense, there are no adverse
effects on the contractors financial statement.
ILOCs on the other hand tie up the contractors bank line. Most contractor failures come from the
inability to manage cash flows effectively. Contractors typically receive contract proceeds a month or
more after the work has been performed. In the meantime, they have obligations to pay suppliers,
overhead, etc. and an available bank line can be crucial to the contractors success. For this reason
alone, bonds can be a much better option. Add to this that the contractor may have to put up collateral
and/or pledge assets to obtain the ILOC and the financial impact can be significant.
Advantage: Bond

Claims
Finally, lets look at what happens in a claims situation. If an owner defaults a contractor who is bonded,
the surety has duty to investigate the claim and ensure that the claim is valid. If the contractor truly is in
default the surety has options to cure the default and is ultimately responsible for limiting the
contractors loss. An ILOC on the contrary is written to the benefit of the holder and the bank must pay
on the demand of the holder. In other words, if the owner declare the contractor to be in default, the
contractors bank is going to honor the letter and release the funds regardless of whether the contractor
has truly breached the contract or not.
Advantage: Bonds
Subcontractor and Suppliers
One final consideration would be the treatment of suppliers and subcontractors. Performance and
payment bonds protect certain subcontractors and suppliers. ILOCs require and owner to work through
the claims process and there may not be enough funds available for subcontractors and suppliers. For
these companies, bonded work is less risky and therefore they may give preference or better pricing to a
contractor that is bonded.
Advantage: Bonds
All of these items should be considered when a contractor is considering the use of an ILOC instead of
surety bonds. Although the cost may be slightly higher, in most cases the benefits of using bonds
outweighs the costs of using letters of credit.