If you are a small business owner, you have likely heard that a single unfulfilled obligation or missed payment can have a huge impact on your operations. If you want to protect yourself and your customers, you can use letters of credit or surety bonds to manage the risks.
While there are some similarities between letters of credit (also called an Irrevocable Line of Credit or ILOCs) and surety bonds, there are serious differences between them. Both can be used as risk management systems, but only one of them can help you save money.
What are Surety Bonds?
Surety bonds are three-party agreements between the surety, obligee, and principal. It’s a contract that provides a guarantee you will fulfill your obligations and tasks. The precise specifics of your surety bond guarantee depend on the bond type you need. If you don’t meet your obligations, someone can file a claim against your bond.
Unlike an insurance claim, if surety companies pay out on this claim, you must repay the company the total amount.
What is a Letter of Credit?
This is also a three-party agreement, but it’s between a bank, buyer, and beneficiary. The letter of credit is a cash guarantee that beneficiaries will be paid for the services or goods provided to a buyer.
When the letter of credit is created, the bank will freeze the buyer’s liquid assets for the total amount of the letter. The buyer can’t access the funds until the bank releases the letter of credit.
If the buyer does not pay for the services or goods provided to the beneficiary, they can use the letter of credit to gain access to the funds that the bank has held in the letter of credit.
The Difference in Claims
If a claim is made against a surety bond, the company must investigate the claim to figure out if it’s valid. The surety company will only pay the claim if it is deemed valid.
A surety company doesn’t want to pay the claim, so they will probably investigate different options, such as trying to find someone else to complete the job. There’s a lower risk of false claims with surety bonds because each claim is carefully investigated.
With a claim against a letter of credit, banks only must verify the correctness and receipt of the documentation required of the letter of credit before the beneficiary is paid. The bank pays letters of credit when it is demanded, if the demand is sent before the expiration date is reached. That means and Oligee can draw on your line with little or no recourse.
The Difference in Costs
If you need to purchase a $50,000 bond, you only pay a percentage of the bond. This amount is usually between one and four percent. With good credit, you can expect to pay one to three percent of the total bond.
A letter of credit usually costs one to three percent of the amount that is covered.
While surety bonds may seem more expensive, this isn’t always the case. The letters of credit freeze the cash assets for the entire amount. With surety bonds, there’s more liquidity with assets. Also, letters of credit require complete collateral, along with the cost of the letter.
If you are unsure of which option to use, contact us today, we’re here to help ensure you choose the right option.