How Does A Cash Surety Bond Work

How Does A Cash Surety Bond Work

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How Does A Cash Surety Bond Work

Have you ever wondered what the difference is between a cash bond and a surety bond? Maybe you run a small business and have been asked to get a bond to bid on a project. Or perhaps you have a friend who needs help posting bail and you’re exploring options. Bonds can be confusing, but understanding the basics goes a long way.

In this comprehensive guide, we’ll break down the key differences between cash and surety bonds in simple, relatable terms. You’ll learn how each type of bond works, their pros and cons, and when to use one versus the other. Whether you’re looking to grow your business or help out a friend in need, you’ll be a bonding expert by the end of this!

What is a Surety Bond?

Let’s start with the basics – what even is a surety bond?

A surety bond is essentially an agreement between three parties:

  1. The principal – This is the person or business who needs the bond. For example, a construction company bidding on a large project.
  2. The surety company – This is the entity that issues the bond. It’s usually an insurance company or bank.
  3. The obligee – The project owner or person requiring the bond. For a construction bond, this would be the client.

Here’s how it works: The principal pays a premium to the surety company. In exchange, the surety company guarantees payment or performance to the obligee if the principal fails to deliver.

For example, Bob’s Construction Company needs to bid on building a new school. The school district (obligee) requires a surety bond to ensure Bob’s Construction will complete the project on time and on budget. Bob goes to Surety Pros Inc. (surety company) and pays them a 2% premium. Surety Pros issues a $1 million surety bond to guarantee Bob’s Construction’s work. If Bob fails to finish the school, Surety Pros pays the school district $1 million to cover damages.

The main benefit of a surety bond is that the principal only has to pay a small premium, not the full value. The risk is shared by the surety company. Surety bonds facilitate commerce by allowing principals to take on projects and obligations they otherwise couldn’t.

Types of Surety Bonds

There are a few main types of surety bonds:

  • Bid bond – Guarantees the principal will enter into a contract if their bid is accepted. Prevents bid shopping.
  • Performance bond – Guarantees the principal will complete the contract. Provides financial assurance.
  • Payment bond – Guarantees subcontractors and suppliers will be paid. Averts liens on the project.
  • License & permit bond – Guarantees compliance with license requirements. Allows work before permit approval.
  • Court bond – Guarantees obligations like court appearances or money judgements. Allows defendants to avoid jail before trial.

Surety bonds are commonly used in the construction industry, but also apply to other fields like business services, energy, transportation, and more. Almost any major contract will require bonding.

What is a Cash Bond?

Now that you know what a surety bond is, let’s contrast it with a cash bond.

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A cash bond is precisely what it sounds like – the principal posts the full bond amount upfront in cash to guarantee payment or performance. The obligee essentially holds this cash deposit during the period of the contract. If the principal fulfills their obligations, the cash is returned. If they default, the obligee keeps the money.

For example, Juan wants to receive an exotic pet license from his county’s Animal Control Department (obligee). They require a $5,000 cash bond which Juan pays upfront. If Juan complies with all regulations and care standards for the pet, Animal Control returns the $5,000 after a year. But if he violates the rules, they keep the cash as compensation.

Cash bonds put all the risk on the principal. There are no other parties involved. The benefit is avoiding surety fees, but the principal loses investment income and liquidity from posting the cash.

Key Differences Between Surety and Cash Bonds

Now that you understand the basics of each bond type, let’s highlight some of the main differences:

  • Parties involved – Surety bonds involve the principal, obligee, and a surety company. Cash bonds are just between principal and obligee.
  • Upfront payment – The principal only pays a small premium for a surety bond, not the full amount. A cash bond requires paying the full bond value upfront.
  • Risk – With a surety bond, the risk is spread between three parties. The principal takes on all the risk with a cash bond.
  • Industry prevalence – Surety bonds are standard for large construction contracts. Cash bonds occasionally apply for smaller projects under $100,000.
  • Collateral – Surety bonds may require the principal to put up collateral. The cash acts as collateral for a cash bond.
  • Fees – Surety bonds require paying a bond premium to the surety company. Cash bonds don’t have fees, but have the opportunity cost of losing investment income.

As you can see, the main trade-off is lower fees vs risk mitigation. Let’s explore when each bond type is advantageous.

When To Use Surety vs Cash Bonds

Deciding between a surety bond and cash bond depends on your specific situation. Here are some general guidelines on when each makes sense:

Benefits of Surety Bonds

  • Don’t need the full amount upfront. Frees up capital for other business uses.
  • Risk sharing with the surety company. You’re not solely responsible if things go wrong.
  • Access to the surety company’s expertise and business relationships. They want to minimize payouts.
  • Required for many licenses, bids, and large projects over $100K. Surety bonds are an industry standard.

Benefits of Cash Bonds

  • Avoid paying bond premium fees to a surety provider. Keep the full value.
  • Faster process without undergoing credit checks or surety underwriting.
  • Principal retains full control over the collateral. Cash is easier to manage.
  • Collateral release is simpler with just obligee approval.

Recommendations

  • For large construction projects, surety bonds are typically required. The process provides important risk protection.
  • When bidding on big contracts over $100K, surety bonds are standard and expected. Get a surety provider involved early on.
  • For smaller contract amounts under $100K, posting a cash bond may work depending on the obligee. The streamlined process can be a perk.
  • If the principal is financially stable with strong credit and assets, a cash bond may be preferable to retain control and avoid surety fees.
  • New businesses or risky principals should use a surety bond for the added risk mitigation. Sureties will help manage inexperience.
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Talk to trusted advisors to determine if your project requires bonding. If so, weigh the tradeoffs of efficiency vs risk management.

The Surety Bond Process

Curious what’s involved in obtaining a surety bond? Here are the typical steps:

  1. Apply – The principal completes an application with their financials, background, capabilities, etc.
  2. Underwriting – The surety company reviews the principal’s credentials and risk profile. This involves credit checks, site visits, document review, and verification. The goal is to verify the principal’s ability to fulfill the obligation.
  3. Bond forms – The bond forms are completed defining the bond type, penal sums, obligations, etc. Terms are mutually agreed upon.
  4. Fee payment – The principal pays the surety company a bond premium, usually 1-15% of the bond amount based on risk.
  5. Bond issuance – The surety company issues the executed bond forms to the obligee.
  6. Obligee review – The obligee verifies the bond is valid and appropriate for the contract.
  7. Potential default – If the principal defaults, the obligee makes a claim to the surety company pursuant to the bond.
  8. Claim investigation – The surety investigates the claim to determine whether the principal is truly in default.
  9. Payment – If default is confirmed, the surety makes payment to the obligee as stipulated in the bond.

The surety bond process provides the peace of mind of transferring risk to an experienced party. The protection comes at the cost of timing and fees.

The Cash Bond Process

In contrast, obtaining a cash bond is simpler with fewer steps:

  1. Terms agreement – The principal and obligee agree to cash bond terms: amount, release conditions, etc.
  2. Deposit – The principal deposits the full bond amount with the obligee, often into an escrow account.
  3. Contract period – The obligee holds the cash bond for the duration of the contract or obligation period.
  4. Obligation review – The obligee reviews if the principal satisfied all obligations.
  5. Return – If obligations are met, the obligee returns the cash bond amount to the principal.
  6. Default – If the principal defaults, the obligee retains the cash bond as financial restitution.

The cash bond process is faster and costs only the opportunity cost of losing investment income on the deposited cash. But the principal undertakes more risk.

Conclusion

We’ve covered a lot of ground on the ins and outs of surety vs cash bonds!

  • Surety bonds involve three parties and transfer risk from the principal. Cash bonds are simpler two-party agreements with the principal retaining all risk.
  • Surety bonds require underwriting and fees, but free up capital. Cash bonds avoid fees but require large upfront payments.
  • Surety bonds are standard for large construction projects and bids. Cash bonds sometimes work for smaller contracts.
  • Take your risk tolerance, finances, and project size into account when choosing your bond type.

Whew, you made it! You’re now a bonding expert armed with the knowledge to make informed decisions. Bonds don’t have to be intimidating. Going surety or cash comes down to assessing the tradeoffs for your unique situation. Weigh both options and partner with reputable advisors. Here’s to happy bonding!

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