Surety Bond Vs. Letter of Credit

by Robert Shaftoe ; Updated July 27, 2017
Surety bond companies charge a small fee, based on a percentage of the overall transaction.

Surety bonds and letters of credit are similar in that both involve third parties acting as a guarantor for transactions. Letters of credit are considered interest-bearing debt for accounting purposes, while surety bonds are a form of insurance used to ensure compliance with construction contracts. Surety bonds are entered into between two parties and a surety bond company, which are typically bond insurance companies. Letters of credit are issued by commercial or merchant banks, and guarantee payments to suppliers.

Surety Bonds

The two parties to a surety bond are the contractor, who serves as the principal, and the property owner, the obligee. If the contractor defaults on the contract, the surety company steps in to ensure that the contract terms are completed. There are four basic types of surety bonds. A payment bond ensures that suppliers and subcontractors are paid for their work. A performance bond ensures that all of the contract's provisions are carried out correctly. A bid bond ensures that the winning bidder to provide general contracting services obtains the necessary payment and performance bonds. Ancillary bonds cover all other necessary contract requirements that are not covered under the payment and performance bonds.

Letters of Credit

Letters of credit are issued by banks to suppliers, referred to as beneficiaries, on behalf of applicants, or the buyers. Letters of credit facilitate specific transactions by functioning effectively as a form of currency that the supplier can accept after presenting documents confirming that the goods in question will be supplied. There are two kinds of letters of credit. A commercial letter of credit is a contractual agreement in which an issuing bank authorizes another bank to make payment on behalf of its client. A standby letter of credit is issued by a bank to a seller to demonstrate the client's ability to make payments.

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