How Payment Bonds Work on Construction Projects
A payment bond is required on many construction projects. In the construction industry, the payment bond is usually issued along with the performance bond. The payment bond forms a three-way contract between the Owner, the contractor and the surety, to make sure that all subcontractors, laborers, and material suppliers will be paid leaving the project lien free. A Payment Only Bond is rarely requested and is usually billed at about 50% of the regular premium.
The Surety is the company licensed by the Insurance Department and the regulatory agencies to write bonds within the state of the country on which the work will be executed. The Contractor, also called the principal, promise in the payment bond that the contract will be executed according to specified terms, while the Surety promises that if the contractor fails on his payments, it will pay damages to all demanding parties.
On a private project, the payment bond might become a substitute for a mechanic's lien. When the principal or contractor fails to pay the suppliers and the subcontractors, they might collect from the surety under the payment bond. Payments under the bond will deplete the penal sum, an amount less than the total prime contract, intended to cover supplier and subcontractor costs.
AIA Payment Bond Form
The most-used Payment Bond form is the AIA A312-2010 Performance and Payment Bond Form. This recent payment bond form specifies some important changes when compared to the previous 1984 AIA 312:
- The A312–2010 Performance Bond adds language clarifying that the owner’s failure to comply with the notice requirements of Section 3.1 does not release the surety from its obligations under the bond except to the extent the surety demonstrates actual prejudice.
- The A312–2010 shortens the notice period for surety default under the bond from 15 days to seven days.
- The limit of the surety’s obligation to the amount of the bond does not apply if the surety elects to undertake and complete the contract itself.
- The A312–2010 Payment Bond also has generally updated language.
In addition to other changes, the period of time in which the surety must answer a claimant’s claim has been increased from 45 days to 60 days, and language has been added stating that a failure of the surety to answer or make payment in the time specified is not a waiver of the surety’s and contractor’s defenses to the claim, but may entitle the claimant to attorneys’ fees, as stated on AIA website.
Many companies are still using the 1984 version of the AIA 312 Payment and Performance Bond. The bonding companies, including sureties, obliges, and principals can amend the bond language to specific circumstances of their construction project.
How Much a Payment Bond Costs
Although not usual, payment bonds can be required without having performance bonds bundled together. The payment bond needs to be purchased during the bidding process and submitted to the owner once the project has been awarded. Payment bonds will normally specify the time and payment to employees, suppliers, and subcontractors. When payment bonds are issued with a performance bond, it is estimated that the premium will be between 1% and 2%, although the actual cost may vary depending on the credit history and background check of the contractor requesting the bond.
Payment Bond Versus Mechanic's Lien
So assuming you are familiar with both terms, some builders do not know the difference between these two. The Mechanic Lien is a type of bond, but it cannot be used against public property, so that's why the payment bond is typically required in government-funded projects. The payment bond is the only option or tool that some suppliers and subcontractors have so they can get paid for their services and labor. Project owners are now using the subcontractor default insurance in conjunction with payment and performance bonds.