Surety Bond Vs Letter Of Credit: Which Option Is Recommended?
The economic environment is changing at a rapid pace, influencing the choices that businesspeople make. Tough decisions have to be made regarding the types of goods and services produced, use of high-tech methods, and distribution of products and services. There is a great need stability. Even if the economy is stable, enterprises still have to monitor their internal operations and keep track of any changes in consumers' habits and lifestyles.
One of the most important problems for businesses is to receive and send payments in a timely fashion. A single missed payment or unfulfilled obligation can have tremendous consequences. The good news is that there are financial products that can help a company control such threats. Both surety bonds and letters of credit ensure financial protection. People wrongly believe that a bond and a letter of credit is the same thing. Although they have many things in common, they do share differences. Knowing how to use these financial products can help an enterprise successfully compete in the industry.
Differences between a Surety Bond and a Letter Of Credit
Surety Bond
A surety bond can be defined as a contractual agreement between three parties: a principal (contractor/company), an obligee (project owner/beneficiary), and a surety (surety bond producer). The bond certifies that the project will be completed and the terms of the contract will be fulfilled. The surety promises to step in and complete the contract in case the principal defaults on the project. Therefore, the obligee, i.e. the one requiring the bond, is able to fulfill their tasks and obligations.
Performance bonds and payment bonds are the most used financial products. A performance bond is issued to one party of a contract as warranty against the failure of the other party to meet contractual obligations. Payment bonds, on the other hand, benefit all parties involved. Payment bonds operate like an insurance policy, in the sense that they provide financial protection or reimbursement against losses. The only difference is that bonding companies do not expect losses.
Letter of Credit
A letter of credit is practically a letter from a bank. It represents a cash guarantee that the beneficiary will be paid if the buyer of products or services is not able to make payments on time. The moment that the seller ships the goods, they have to forward the formal documentation as so defined in the letter of credit. When a letter of credit is created, the bank puts a hold on the buyer's liquid assets. Buyers who do not want to allow the financial institution to freeze their funds have to pay up front. Attention needs to be paid to the fact that a letter of credit is date specific, which means that it is limited in terms of time.
Different Markets Require Different Financial Products
Several types of surety bonds exist in the world. These financial instruments are sensitive to market needs, surety bond producers taking consideration of local requirements and customer needs. In Europe, a surety bond can be supplied by a bank or surety company. When the financial product is issued by a bank, it is called a guarantee. A considerable percentage of the value of the market for surety bonds is due to customers from the construction sectors. At least, this is the case in Spain. Guarantees across European countries have risen to 9 billion euros. Nonetheless, businesses in Europe are more inclined to use letters of credit. The main problem is that these instruments are becoming harder and harder to obtain because of the financial crisis.
The primary guarantee instrument used in America is the letter of credit. The standby letter of credit works as a guarantee autonomously of the contract concluded between the seller of goods and services and the buyer. As a matter of fact, the letter of credit is the counterpart to the European bank guarantee. Surety bonds are very common in the United States, premiums have amounting to 3 billion dollars. Private, as well as public organizations purchase bonds directly from the issuers. The biggest customers are insurance companies, pension funds, and corporations. These organizations have powerful credit profiles and they are not required to provide collateral. Issuers provide them solutions that support business performance and foster growth.
Which Financial Product Offers More Protection?
Surety bonds and letters of credit can be successfully used to manage financial risks. The instruments guarantee payment against failure to meet contractual obligations. It does matter if a business owner chooses one option or the other. Many agree with the fact that surety bonds provide the best protection if a contractor defaults. In addition to financial security, sureties offer owners the guarantee that the business will succeed. They can be used in real estate contracts and infrastructure projects, but not only. The contract does not affect the principal's cash and, most importantly, it does not expire.
It can be argued that surety bonds take things one step further. To be more precise, the contract is good for the entire duration of the project and the contractor is free to access more bank credit. As a rule, sureties oversee the bonded company's work schedule. If there are issues that can potentially affect the project, then they will be identified on time. Even if the problems have nothing to do with the project, information is shared between the parties and problems are stopped even before they occur. The main idea is that an enterprise takes fewer risks with a surety bond.
Final Considerations
Businesses regardless of size need a backup plan for payment. There is no way of knowing what can go wrong and having a backup plan can turn out to be helpful. Surety bonds and letters of credit are the most prevalent financial instruments. Opting for one or the other involves careful consideration. It is necessary to assess one's needs and concentrate on the avenues that lead to business growth. Sureties are largely considered the most advantageous option. It is important to understand how the process works and under what circumstances one is responsible for payment.