Surety Bond Basics: What to Know Before You Buy

By Derrick Lin

Whether you’re a veteran business owner or looking to start your first business, you’re going to need a surety bond. Oftentimes, first-time owners don’t hear about surety bonds until they find out they need them; an added learning curve (and unexpected expense) in the middle of setting up your new business is probably the last thing you need during such a stressful time.

Understanding surety bonds before you encounter them in your licensing process will shorten your application time and give you an accurate idea of the price you’ll pay when you’re ready to purchase a policy.

Bond Basics

First things first, what exactly is a surety bond? Put simply, it’s an agreement that guarantees certain tasks will be completed in an appropriate fashion. A surety bond, regardless of type, will always involve the following three parties:

Obligee. The party that requires the purchase of a surety bond. This is usually a government agency that is protecting itself and consumers against financial loss.

Principal. The party that purchases the surety bond. This is usually the business owner that is guaranteeing quality work in the future.

Surety. The party that enforces the terms of the surety bond and guarantees the business owner meets his obligations.

Determining the Price (or Premium) of Your Bond

No surety bond will be priced the same, but there are four main factors that will determine your bond premium:

1. Bond Amount. The premium you pay is a percentage of the total bond amount. Bond amounts, or amount of coverage required by the obligee, for business owners can range anywhere from $10,000 to over $100,000 depending on your state and the industry you are in.

Note that “bond amount” (coverage amount required by the governing agency) is different than “bond cost” (amount you will actually pay for your bond).

For example, if you want to begin a career as a mortgage broker and you have a 700 credit score, you can expect to pay a 1-2 percent rate of the $50,000 bond amount requirement--or $500-1000 based on standard market pricing.

There is such a wide spectrum of bond amounts because each state and industry has proven to have a different likelihood of consumer claims, known as “claim ratio,” and unethical owner behavior. The number of incidents or specific conditions per area have been factored into each state and industry designating its own bond amount for business owners. The greater the evidence of risk involved equates to a higher bond amount required.

2. Underwriting Risk. The underwriting process for surety policies, just like consumer or business insurance policies, serves the purpose of thoroughly and accurately assessing risk. Underwriting for bonds varies depending on the bond type and industry, but in general, it is when the surety provider evaluates the principal’s proposed agreement or business from a number of angles. They perform an analysis of risk of the business and the industry as a whole. The principal’s individual risk is based on personal and background information (usually reviewing the applicant’s credit report is sufficient) in order to determine qualifications and costs for the bond.

If you are in a higher-risk industry or profession, you can expect your bond premium to be higher, respectively. Risk is pushed higher or lower on the scale depending on claim activity from previous policies. Underwriters are more hesitant to sign off on bonds when the likelihood of a claim is high. Surety bonds are unlike other types of insurance (i.e., home, auto, or life) because accidents and claims are expected on those types of policies.

Bonds, on other other hand, do not transfer any liability away from the policyholder to the surety company and claims are not expected to occur. They are designed as financial guarantees for meeting industry standards, promoting ethical practices, and allowing only qualified persons to conduct business or provide certain services.

3. Bond Type. Some bond types cost more than others because the likelihood for claims is greater in some industries than others. For example, notary bonds are very low risk and usually have a $10,000 bond amount. Notary bond holders only pay $50 total over four years for their bond and don’t even need a credit check to be issued for a bond. This is because so few claims are made on notary bonds, no matter where the business operates in the country.

Auto dealer bonds are in the middle of the pack when it comes to bond cost. But keep in mind that amounts for the same bond type vary by state, due to different risk factors associated with each state.

Some of the most expensive bonds are in the construction industry. They are called performance bonds, and the bond amount is often over $100,000. The hefty price comes from the many variables that must be considered in the construction industry, such as bid amounts, bid dates, and possible weather conditions, which will vary by state. A qualified contractor with a good financial record will be able to pay a premium of about 2.5 to 3 percent of the bond amount.

4. Credit Score. Generally speaking, the higher your credit score is, the lower your bond premium will be. A credit score of 700 or more will usually only require a business owner to pay 1 to 3 percent of the total bond amount, depending on what industry they are in. When the credit score drops below 680, the premium rate can increase to 4 to 10 percent depending on other financial credentials.

That being said, notary bonds are so low-risk that they don’t even need a credit check to be issued. And, unlike riskier professions, an auto dealer only needs to provide the information that would be on a credit report to qualify for an auto bond. In comparison, construction professionals must go through a more extensive credit check and evaluation of their financial history.

Prospective business owners with low credit scores aren’t necessarily out of the running for a surety bond, though. For example, auto dealers with premiums over $2,100 can be financed, so they can get the bond on loan to start their businesses. This enables dealers to open and operate in compliance with the law, begin generating revenues from sales, and have a foundation to begin making payments on their financed policies.

Financing options can be extremely helpful for some applicants, but keep in mind that you must qualify for such programs as determined by the surety. Also, you will incur financing fees in addition to the premium by choosing this route for purchasing your bond.

Bonds: More Than Just Another Business Expense

While surety bonds are an initial cost to your business, they will help you attract consumers. If a business can say that it is legally licensed and bonded, then consumers will know that they are buying from an honest and reputable company.

Additionally, the surety bond contractual guarantee of upholding professional and ethical standards will push owners who cannot meet these standards out of the industry. Bonds can actually eliminate excess competitors in a given area who are unqualified to do business, leading to a healthier and more sustainable marketplace, which benefits consumers and business owners alike.