Surety Bond vs Letter of Credit: What's the Difference?

Surety bonds and letters of credit are both used in business transactions to build trust and financial assurance between two parties. While these two financial instruments have similar functions, there are different implications for the parties involved.

Surety Bond

A surety bond is a three-party agreement which ensures contractual obligations will be met. Having a bond tells whoever you are working with that you can reimburse any costs or damages if the contract is broken. This is more trustworthy as coverage is supported by an insurance company.

Letter of Credit

An letter of credit (LOC) is a bank-issued letter guaranteeing complete and timely payment from buyer to seller (or debtor to creditor). They are commonly used in international trade and contract-based industries to ensure proper transfers of funds and completion of performance agreements.

5 Key Differences Between Surety Bonds and LOCs

While surety bonds and letters of credit have similar purposes, there are five main differences to consider when determining which is best for you.

1) Parties Involved

There are three parties in a surety bond contract:

Principal: Entity purchasing the bond
Obligee: Entity requiring the bond
Surety: Company providing the bond

The obligee requires the principal to purchase a bond in order to conduct business or begin a project.

Letters of credit also include three parties:

Applicant: Requester of the LOC, “buyer”
Beneficiary: Party protected by the LOC, “seller”
Bank: Entity issuing the LOC

In both cases, the surety or bank guarantees to cover any financial liabilities if the contract is breached.

2) Coverage

When you purchase a surety bond, it typically covers the full contract amount and any applicable project costs. For example, project costs can include:

Subcontractors
Workers
Suppliers
Maintenance

An LOC typically only covers 5–10% of the total project cost or payment total and does not protect subcontractors, workers or suppliers. This is why the Miller Act requires government entities to exclusively accept surety bonds for major contracts.

3) Claims Investigations

For both surety bonds and LOCs, the obligee/beneficiary can file a claim to recoup financial damages. Surety bond claims undergo an evaluation process to ensure validity. The principal is also notified and has a chance to resolve the situation with the obligee on their own. The surety only pays if the claim is validated.

In contrast, banks pay out LOC claims with no further investigation or explanation. The bank has the obligation to perform and pay the beneficiary regardless of the claim’s validity.

4) Cost

Surety bond premiums are determined by factors like credit score, project size, business financials and industry experience. For qualified applicants, bond prices are typically 1–5% of the total coverage amount.

Letters of credit fees are usually 0.5–1% of the credit total plus a 100% cash collateral deposit. Banks only evaluate the applicant's financial situation and assets when determining the price.

5) Duration of Terms

Payment and performance bond terms last until the principal is officially released of their obligation. The coverage you purchase remains the same until the contract is complete. You must renew your bond annually as needed, but the coverage remains the same.

LOCs also typically last one year and require annual renewal. However, the terms could change overtime as you only have fixed terms for one year with certain types of LOCs.

Is a Surety Bond or a Letter of Credit Best for Me?

You may be wondering, what’s better for me — a letter of credit or a surety bond? The answer depends on your unique circumstances and priorities. Surety bonds are often more economical and safer in the long run, but there are benefits to both options.

Advantages of Surety Bonds Over LOCs

Validated claims: Sureties investigate claims for validity making them less likely to have fraudulent claims.
Lower price: In the long run, surety bonds are often less expensive than LOCs that have hidden renewal fees and collateral requirements.
No credit impact: Surety bonds free up credit for other needs, whereas LOCs count towards your credit limit.
No collateral: Unlike LOCs, most surety bonds do not require collateral. This frees up your working capital.
Greater stability: Sureties evaluate a principal’s credit, character and work history when approving bond applications. With LOCs, banks only take financials into consideration which may not fully represent a buyer’s ability to complete a contract.

Advantages of Letters of Credit Over Surety Bonds

Good for “liquid” businesses: If your business has high cash reserves to set aside collateral, an LOC may be a good fit for you.
Personalized terms: An LOC offers more flexibility to personalize terms between two parties. You can more easily define when and how transactions should be completed than with surety bond forms.
Quick funds transfers: With no claims investigation process, the payment transfer to the beneficiary is more efficient.

Which Bonds Are the Most Similar to Letters of Credit?

Financial guarantee surety bonds are a helpful alternative to letters of credit in some situations. Bonds relating to project completion and payment agreements often meet the same needs as LOCs.

SuretyBonds.com offers multiple bonds that can replace your letter of credit:

Whether you choose to purchase a surety bond or letter of credit depends on your unique needs. Before making your decision, consider the benefits and differences in coverage for each.

If you have questions about surety bonds, call 1 (800) 308-4358 or email [email protected] to talk to an expert today!

Surety Bond vs Letter of Credit