Why Posting a Performance and Payment Bond Is Better Than an Irrevocable Letter of Credit

When a project owner hands you a contract and asks for proof of financial security, two options usually come up: post a performance and payment bond, or provide an irrevocable letter of credit. 

On the surface, the letter of credit can seem like the more straightforward path. Look closer, though, and the picture changes. 

For most construction and development projects, a performance and payment bond offers stronger protection, better financial flexibility, and fewer hidden risks. Find out more about why performance and payment bonds are usually the better choice for contractors and project owners.

What Is a Performance and Payment Bond?

A performance and payment bond is a two-part surety contract guaranteeing that a contractor completes a project in accordance with the contract terms and pays all subcontractors, suppliers, and laborers involved in the work.

A performance bond obligates the surety to respond if the contractor defaults, either by financing the contractor to continue, arranging for a replacement, or paying out up to the bond's penal sum. 

A payment bond protects every subcontractor, supplier, and laborer on the job, ensuring they're paid even if the prime contractor fails to do so.

Since both bonds are usually issued at 100% of the contract value, a $1 million project generates $1 million of performance coverage and a separate $1 million of payment coverage under a single combined premium.

On federal construction contracts valued at $150,000 or more, the Miller Act requires both bonds. Most states have enacted Little Miller Acts with similar requirements for state-funded projects, which is why performance and payment bonds are the standard on public work across the country.

What Is an Irrevocable Letter of Credit?

An irrevocable letter of credit (ILOC) is a bank-issued financial guarantee that commits the bank to pay a project owner a specified amount once required documentation is presented.

The "irrevocable" designation means the terms can't be changed or canceled without the agreement of all parties. When an owner draws on an ILOC, the bank verifies that the paperwork complies with the letter's terms and releases the funds. 

In this context, the bank has no obligation to investigate whether a default actually occurred and doesn’t have a role in completing the project. Where a surety bond is a project recovery tool, an ILOC is purely a financial transfer mechanism.

5 Reasons Surety Bonds Are Better Than Irrevocable Letters of Credit

Both instruments exist to give project owners financial assurance, and in limited circumstances (a private project where a contractor can't yet qualify for bonding, for instance), an ILOC may be the only available option. 

For most contractors on most projects, though, the differences below explain why bonding is the smarter path:

1. Bonds Protect the Owner, the Subcontractors, and the Contractor

When a contractor defaults on a bonded project, the surety investigates what happened and takes active steps to remedy it — financing the existing contractor to continue, bringing in a replacement, or paying out to the bond's penal sum. Project owners aren't left to manage the fallout alone.

According to a 2022 study by Ernst & Young, when defaults happen on unbonded projects, completion costs run 85% higher than on bonded ones. Every construction default expert interviewed for that study confirmed that sureties manage project recovery more effectively than owners do.

An ILOC pays. A bond responds. For the project owner, that distinction matters enormously when something goes wrong.

Subcontractors, suppliers, and laborers have no standing to claim under an ILOC, which is a contract solely between the owner and the bank. A payment bond gives them a direct path to recovery if the contractor fails to pay, which also reduces the risk of mechanics' liens clouding the owner's title.

2. The Real Cost Comparison Goes Beyond the Stated Rate

On paper, ILOCs often look cheaper. Banks typically charge 0.5–1.5% of the covered amount annually, while performance and payment bond premiums generally run 1–3% of the contract value. The critical difference is that a bond premium is a one-time fee for the full project term, while the ILOC fee resets every year. On a two-year project, that lower annual rate compounds, and that's before accounting for what an ILOC does to a contractor's balance sheet. 

To secure an ILOC, contractors typically must pledge collateral in the form of cash, a draw on an existing credit line, or other assets that the bank perfects through a public UCC filing. Those assets are effectively frozen for as long as the ILOC remains outstanding, meaning they’re unavailable for equipment purchases, payroll, or working capital. Banks often layer in origination and utilization fees on top of the stated rate, and each annual renewal may bring additional charges.

Surety bonds are unsecured credit. Sureties almost never make a UCC filing unless a claim arises, so the contractor's assets stay available for operations and the bond carries no balance sheet liability. For a growing contractor managing tight cash flow, that liquidity often determines whether they can pursue the next contract.

Since collateral requirements vary by lender and situation, contractors should discuss the specifics with a surety professional before assuming the two instruments cost the same.

3. Bonds Give Contractors Meaningful Protection Against Wrongful Draws

Under an ILOC, a project owner can draw the full amount on demand by presenting the required documentation. The bank pays regardless of whether the underlying default was legitimate, and by the time a contractor can contest it through litigation, the financial damage is already done.

Surety bond claims work differently. Before paying, the surety investigates whether a default actually occurred, notifies the principal, and gives the contractor the opportunity to respond. Invalid or exaggerated claims can be challenged and denied. 

A bank issuing an ILOC has no stake in the contractor's outcome. In contrast, a surety carries shared exposure on the bond and a genuine interest in sorting out what actually happened.

4. Bonds Provide Continuous Coverage Through the Life of the Contract

ILOCs are typically issued for one-year terms, which means annual renewals on any project that runs longer. Each renewal is a new negotiation, and if the contractor's financial picture has weakened, the bank may demand additional collateral, increase fees, or decline to renew altogether. A lapsed ILOC mid-project leaves the owner without coverage and puts the contractor in breach of contract.

Performance and payment bonds follow the contract term, including any agreed maintenance or warranty period, without annual renewal. A single project premium for the contract duration buys continuous coverage from groundbreaking through final acceptance, and if the scope grows through change orders, the surety can adjust the bond without requiring the contractor to renegotiate collateral.

5. Getting Bonded Signals Something an ILOC Can't

Obtaining a surety bond requires passing underwriting. A surety evaluates the contractor's financial strength, work history, management team, and experience through the lens of the classic three Cs of surety: capital, capacity, and character. A bank issuing an ILOC focuses on whether the collateral is adequate and largely leaves contractor competence out of the equation.

For project owners, that underwriting backstory matters. The previously mentioned EY/SFAA study found that prequalification was performed on 96% of bonded projects, compared to 61% of non-bonded ones. Additionally, five times as many project owners reported that bonded projects are more likely to finish on time or ahead of schedule than non-bonded ones.

A surety bond is a third-party endorsement of a contractor's ability to perform, backed by an underwriter who has reviewed the books and decided the risk is worth taking. By receiving a bond, contractors can signal their competence to project owners, giving them more credibility than an ILOC would.

Work With a Surety-Only Agency That Knows Construction Bonding

For larger contracts, complex projects, or situations involving credit challenges, navigating the performance bond process is easier with a specialist in your corner. ProSure Group is a surety-only agency and wholesaler licensed in all 50 states, working with more than 30 A.M. Best-rated "A or better" surety carriers. Since ProSure focuses exclusively on surety and fidelity bonding, our team understands what underwriters look for and how to position your application effectively.

Learn more about our surety bond services today. If you’re ready to get started, please apply for a bond today. 

Have questions? Call ProSure Group at 800-480-3883 or email contractbonds@prosuregroup.com to get started.