Two surety bonds issued on the same construction contract. The performance bond covers completion if the contractor defaults. The payment bond covers the subcontractors and suppliers so they do not lien the property for work the contractor failed to pay for.
The longer version
The two bonds answer two different risks, and lenders care about both for different reasons. The performance bond answers completion risk: if the contractor defaults, the surety either completes the project itself, finances the existing contractor, or pays the cost of completion up to the penal sum. The payment bond answers lien risk: subcontractors and suppliers who are not paid can claim against the bond rather than record mechanics liens against the collateral.
Both are issued by a surety rather than an insurer, and the distinction matters. Insurance prices an expected loss. A surety underwrites a contractor it expects to perform, and it has recourse back against that contractor after it pays. That is why surety underwriting looks like credit underwriting: work on hand, bonding capacity, financial statements, and completed-project history.
On federal public projects the payment bond is statutory. The Miller Act requires performance and payment bonds above a contract threshold, because a federal building cannot be liened, and state equivalents, usually called Little Miller Acts, extend the same idea to state and municipal work. Private construction has no such requirement, so whether bonds exist at all is a loan negotiation rather than a given.
What a lender checks is narrower than people expect. The surety's rating and its listing on the Treasury Department's approved list. The penal sum against the current contract value, including executed change orders, since a bond written to the original contract leaves the increase uncovered. Whether the lender is named as dual obligee, which is the clause that lets the lender claim directly. And the notice provisions, because sureties enforce them strictly and a missed notice can forfeit the claim.
The dual obligee rider is the item that most often gets missed in a closing. Without it the bond runs to the owner alone, and a lender that has stepped in after a default finds it is not a party to the instrument it underwrote the deal around. It arrives as a separate document from the bond itself, which is why it goes on the checklist as its own line rather than as part of the bond.
Common questions
- What is the difference between a payment bond and a performance bond?
- A performance bond guarantees that the work gets completed if the contractor defaults. A payment bond guarantees that subcontractors and suppliers get paid so they do not lien the property. They are usually issued together on the same contract, by the same surety, and priced as one.
- Who pays for payment and performance bonds?
- The contractor buys them and prices them into the contract, so the owner pays for them indirectly. Premiums are typically quoted as a percentage of the contract value and scale with the contractor's credit and the size of the job.
- What does dual obligee mean on a bond?
- A dual obligee rider names the lender alongside the owner as a party entitled to claim under the bond. Without it the lender has no direct claim, which matters precisely in the situation the bond exists for. It is a separate document from the bond and belongs on the closing checklist as its own item.
- Are payment and performance bonds required on private construction loans?
- Not by statute. The Miller Act and its state equivalents require them on public work. On private projects bonding is a negotiated requirement, and lenders often require it above a contract size threshold or where the contractor is unfamiliar.
- What is the penal sum of a bond?
- The maximum the surety will pay, usually set at the contract value. It does not move on its own, so a contract that grows through change orders can outrun the bond unless the penal sum is increased. Checking the bond against the current contract value is part of construction loan administration, not just closing.
- The Construction Loan Closing ChecklistBonds among the deliverables.
- The Commercial Loan Documentation GuideSurety documents in the package.
- Commercial Real Estate Due Diligence ChecklistContractor and surety diligence.
- Construction loan managementDraws, lien waivers and the inspection record in one place.