Surety Bonds vs. Irrevocable Line of Credit (ILOC)
What is a Surety Bond?
Surety Bonds are three-party agreements involving the surety (bonding company), obligee and principal. (Note: Surety Bond Producers are also involved to facilitate the process, and find the best rates for customers.) Basically, an obligee is requiring a principal to purchase a surety bond in order to guarantee that they will perform per the terms of a contract or agreement. By paying a premium for a bond, which is typically 1-3% the bond amount, the principal purchases the financial backing from deep pockets of the surety bond company. Collateral is only required from the principal in unique, very high risk situations where the likelihood of a claim is increased. Even in these circumstances, the surety will often accept an increased premium over the need for collateral.
What is an Irrevocable Line of Credit (ILOC)?
An Irrevocable Line of Credit is also a guarantee of performance, but it is handled differently than a surety bond. An ILOC is a letter of credit issued to an obligee to guarantee that the principal will perform, but in creating this letter of credit, the bank freezes the principal’s liquid assets in the total amount of the ILOC. Since this amount of funds is frozen by the bank, the principal cannot access it until the bank releases the line of credit. If a claim arises, the obligee is able to use the letter of credit to access the funds held by the ILOC. Obtaining an ILOC can be tough for principals that truly value their liquidity.
Comparing the Costs
While at first glance, the premium rates and service fees for a surety bond may make it appear to be more expensive than an ILOC, potential customers look at the whole picture before coming to such a determination. When you consider the long run, surety bonds usually end up being less expensive than ILOCs and can help principals save money. While service fees for an ILOC (roughly 1% the amount of the ILOC) are typically lower than premiums bond rates for a surety bond (roughly 1-3% the bond amount), purchases of an ILOC have a bank freeze cash assets for the total amount of the ILOC. Customers that purchase surety bonds typically do not have a collateral requirement, and experience much more liquidity. They are able to invest the freed up assets and make money by doing so. In a money market account, for example, the principal could earn 3-4% on dividends, vice having their cash made off-limits to them. This is a clear illustration of how surety bonds can save you money when compared to an ILOC.
Conclusion: Surety Bonds are often the Better Option!
For those who qualify, surety bonds are more often than not the best choice for prospective principals for numerous reasons. As you can see, in the long run they usually end up being cheaper than ILOCs. Not having to put down collateral for a bond allows customers to invest their capital, which would not be the case for those who purchase ILOCs. Being more liquid provides increased flexibility in day-to-day operations. Customers deciding between a surety bond and ILOC must make themselves informed of the different options available to them, and by doing their homework, and not just looking at premium rates and service fees, they will see that surety bonds can be much more beneficial to their company.