If you own a business and are looking to protect yourself and your customers, you’ve likely heard two terms:
- Surety bonds
- Letters of credit
Both of these are three-party agreements that offer financial protection in certain instances, but both operate very differently from one another. We’ve heard that letters of credit can be a suitable replacement for surety bonds, but they ultimately lack the protection and ease provided by certain types of bonds.
Find out which is best for your business by learning more about both types of protection.
What is a Letter of Credit?
A letter of credit is essentially a payment mechanism that guarantees that a beneficiary will be paid. This guarantee is provided by the bank or financial institution that provides the letter. There are three parties involved in this agreement:
- The beneficiary: the person who is to be paid
- The buyer: the person who is purchasing the goods or services provided by the beneficiary
- The bank or institution that provides the letter of credit
The bank will generally freeze the assets of the buyer in the amount owed to the beneficiary. These assets cannot be accessed until the bank releases the letter of credit.
What is a Surety Bond?
Surety bonds are also three-party agreements that involve:
- A principal: the party that guarantees they will fulfill a certain duty
- An obligee: the party being promised that a certain contract will be fulfilled
- A surety: the company that the surety bond is purchased from
The principal will purchase a surety bond from a surety, which protects the obligee should the principal not fulfill their end of the contract or agreement.
Why Are Surety Bonds Better?
Surety bonds have several key benefits over letters of credit:
- There is a greater fraud risk involved with letters of credit. When a claim is made on a surety bond, the claim is thoroughly investigated by the surety
- Liquidity: letters of credit freeze assets and credit capacity, which means they cannot be invested or used
- Claims: banks generally do not have a claims department, so clients generally have to handle the claims process themselves
- Costs: surety bonds generally are the most cost-effective in the long run, and they do not come with any hidden fees
- Banks have the ability to give your money away in letter of credit situations without your say. With a surety bond in place, there is an additional layer of protection
Disclaimer: this is for informational purposes only and is not intended to be legal advice. If you need legal counsel, please contact an attorney directly.
A surety bond is generally going to be better for your business and your customers. If you need help obtaining one for your business, get in touch with The Patrick J. Thomas Agency today.