Surety bonds and letters of credit are both used to manage risk and provide a form of financial guarantee for the people and organizations your business works with. If you’re not sure whether a surety bond or a letter of credit is a better choice for your business needs we’re here to help you understand your options!
What is a surety bond?
A surety bond is an agreement between three parties:
The surety: the business that underwrites the bond
The principal: the business who purchases the bond
The obligee: the individual, business, or agency that requires the bond
The surety bond provides a form of financial security for the obligee as the surety agrees to pay the obligee compensation up to the bond amount should they make a legitimate claim against the bond. The principal must repay the surety if they pay a claim made on the bond.
What is a letter of credit?
A letter of credit is also an agreement between three parties:
The bank: the institution who issues the letter
The buyer: the business making a purchase
The beneficiary: the supplier of the goods or services
When a bank issues a letter of credit they put a hold on the buyer’s assets equaling the credit amount. The buyer will not be able to access these funds while the letter of credit is active. Should the buyer fail to pay for the goods or services the beneficiary can claim against the letter.
Why choose a surety bond over a letter of credit?
-Increased cash liquidity and flexibility
A letter of credit reduces available cash as the bank will freeze cash assets that are tied into the credit line. This freeze can prevent your business from adapting to changing cash flow needs. A surety bond has none of these cash restrictions.
-Increased security against claims
Surety bonds have a rigorous claims process that can help protect your business from fraudulent claims. This is often not the case for claims made against a letter of credit where the claim process is much simpler.
-Stronger defense options
Claims made against letters of credit cannot be defended. If a claim is made against a surety bond the surety company will work with your business to help you defend the claim.
-Clear fee structure
Letters of credit can often appear to be the cheaper option, however there can be hidden fees that can significantly push up the cost of the letter. Surety bonds have a premium cost that is fixed for the duration of the bond.