Surety Bonds vs. Letters of Credit: What's the Difference?

July 27, 2023

A surety bond is a written contract in which one party guarantees another party’s performance or obligation to a third party. It provides monetary compensation or satisfactory completion of an obligation should there be a failure to perform specified acts within a stated period of time.

A letter of credit, also known as a credit letter, is a promise by a bank that guarantees the agreed-upon payments will be made to a specific person under specific conditions.

There are three parties to a surety bond: the principal, the obligee and the surety

Parties to a Surety Bond

Principal – This is the person or business required to be bonded by the obligee. The Principal is obligated to the obligee to pay and/or perform according to a law, ordinance, rule, regulation, contract, license or permit.

Obligee – This is the party that requires the principal to provide the bond. The obligee is protected from loss by the surety if the principal fails to fulfill their obligations.

Surety – This is the insurance carrier that guarantees the obligations of the principal to the obligee.

A letter of credit’s parties include the applicant, the beneficiary and one or more banks. 

Parties to a Letter of Credit:

Applicant – This is the party who requests their bank to issue a letter of credit.

Beneficiary – This is the party who receives the payment.

Bank – There are a number of banks that can be involved in a letter of credit, though they can have dual roles.

• Issuing bank: The bank that creates or issues the letter of credit at the applicant’s request.
• Negotiating bank: Working for the beneficiary, this bank acts as a liaison with other banks involved.
• Confirmation bank: The bank that guarantees payment to the beneficiary as long as the requirements in the letter of credit are satisfied. (May be the same bank as the negotiating bank.)
• Advising bank: Also known as the notifying bank, this bank receives the letter of credit from the issuing bank and notifies the beneficiary that the letter is available. (May be the same bank as the negotiating and confirming bank.)

Coverage Differences

Surety bonds cover 100% of the contract amount. The performance bond ensures full project completion, while the payment bond protects the subcontractors, workers and suppliers.

A letter of credit can be issued for any percentage of the project contract amount, though it’s generally between 5-10%. Subcontractors, workers and suppliers are not protected.

Claim Differences

With a surety bond, the surety provider investigates the case if a contractor defaults, and can:

• Provide financial or other support to the contractor
• Ensure the completion of the project up to the bond’s penal sum
• Choose another contractor
• Cover the bond’s penal sum for the project owner (for performance bonds) and for subcontractors, workers and suppliers (for payment bonds)

In the case of a letter of credit claim, the project owner requests the payment of the letter of credit within its period of coverage and the financial institution completes it. However, the owner is responsible for completion of the project as well as claims by subcontractors, workers and suppliers. 

Advantages of a Surety Bond vs. Letter of Credit

There are several key advantages surety bonds have over letters of credit. Surety companies are typically pretty flexible when it comes to covenants, while banks are more restrictive and may require extensive financial reporting.

Other advantages include:

• Surety bonds aren’t credited against a company’s bank line, while a letter of credit can tie up a company’s credit capacity.
•  A surety is generally considered an unsecured creditor and will rarely require filing of public documents (UCC) publicizing their lender status. In the case of letters of credit, if a bank chooses to take a security interest in the client’s assets, the UCC filings must publicize their secured lender status.
• Because the surety requests proof of a company’s default from the obligee and works with the principal to identify defenses, surety bonds protect the principal from the obligee taking possession of the bond proceeds without merit. However, a letter of credit may be drawn down at any time without any reason, leaving the company defenseless.
• Finally, surety rates are directly tied to the credit quality of the principal and the types of obligations handled, and therefore tend to be more stable. Letters of credit can be volatile, and in addition to a stated rate, may require commitment and issuance fees.