When developers or contractors undertake a project, the party hiring them—whether it’s a government agency, private investor, or municipality—wants to ensure it gets completed according to the contract's terms. That’s where financial assurance tools play a vital role. Two of the most common? Surety bonds and letters of credit (LOCs).
Though they serve a similar purpose, these two instruments are very different in structure and their impact on a business.
What Is a Surety Bond?
A surety bond is a three-party agreement:
- Principal – The contractor or developer
- Obligee – The project owner or entity requiring the bond
- Surety – The insurance company backing the bond
If the principal defaults on their obligations, the surety steps in to fulfill the commitment or pay the obligee—after a formal claims process.
What Is a Letter of Credit?
A letter of credit (LOC) involves three man parties:
- Applicant – The contractor or developer
- Beneficiary – The party requesting financial assurance
- Issuing Bank – The financial institution providing the LOC
An LOC guarantees payment to the beneficiary if the applicant fails to meet the contract terms. The bank can draw directly from the applicant’s account or require full collateral to issue the LOC.
Why It Matters to Developers
If you’re building homes, subdivisions, or commercial developments, the financial instrument you choose could potentially limit your company's ability to grow. Here’s how they stack up:
Surety Bonds Offer Flexibility and Preserve Capital
- No need to post 100% collateral
- Sureties evaluate your credit and experience
- Preserve cash for labor, materials, and expansion
- Grow your program as your business succeeds
Letters of Credit Can Restrict Growth
- Funds used as collateral are frozen
- Any claim has the potential to be paid without a proper investigation
- Each LOC ties up new capital
What Surety Agents Should Know
Helping clients choose between bonds and LOCs is a strategic opportunity. Here’s how agents add value:
- Educate clients on the long-term benefits of bonds
- Support growth with scalable programs
- Build trust through prequalification standards
- Leverage technology like The Hub for efficiency
Real-World Scenarios
- Subdivision Developers: Bonds fulfill municipal improvement guarantees while preserving working capital.
- Commercial Contractors: Bonding lines support multiple projects without repeated approvals.
- New Builders: Surety capacity grows as performance is proven—LOCs don’t.
Key Differences at a Glance
| Feature |
Surety Bond |
Letter of Credit (LOC) |
| Parties Involved |
Principal, Obligee, Surety |
Applicant, Beneficiary, Bank |
| Instrument Type |
Conditional Guarantee |
Demand Instrument |
| Collateral Required |
Typically none |
Usually 100% of the LOC amount |
| Capital Impact |
Preserves liquidity |
Ties up working capital |
| Claims Process |
Investigated and conditional |
Paid on demand |
| Regulatory Backing |
Regulated insurance product |
Banking regulations |
| Preferred By Public Entities |
Yes |
Less common |
| Scalability |
High—flexible programs |
Limited—collateral-dependent |
| Relationship Type |
Advisory with surety & agent |
Transactional with bank |
In Summary
Surety bonds and letters of credit both provide financial guarantees, but only one is built with your business’s growth in mind.
Surety Bonds Win On:
- Preserving working capital
- Supporting business scalability
- Protecting against unfair claims
- Fostering long-term relationships
Letters of Credit Fall Short On:
- Collateral flexibility
- Risk management
- Ease of expansion
- Strategic partnership potential
Final Thought
Don’t treat bonds and LOCs as interchangeable. For many developers and contractors, surety bonds are the smarter, more strategic choice.
Want to explore bonding options that align with your goals?
Talk to a Merchants surety expert today.
Surety bonds are issued by Merchants Bonding Company through insurance agents. Contact your local insurance agent or use our Find an Agent tool. They will guide you through the process, informing you of what documents and information are needed by the surety (Merchants Bonding Company) to underwrite your bond.
All information provided is subject to change.