Performance Bond vs Letter of Credit: Which One Actually Protects Your Construction Project?

A performance bond guarantees project completion and keeps your credit lines open. A letter of credit freezes your cash and pays out the moment compliant paperwork arrives at the bank — no questions asked. For Ontario contractors juggling multiple projects, choosing the wrong instrument can lock up hundreds of thousands of dollars in working capital you cannot afford to lose.

We work with contractors across Durham Region and Ontario who face this decision on nearly every project. The two instruments look similar on the surface — both provide financial assurance to project owners — but their mechanics, costs, and consequences could not be more different. Here is how they actually compare, what Ontario law requires, and how to decide which one fits your situation.

How Each Instrument Works

Performance Bonds: A Three-Party Guarantee

A performance bond creates a three-party relationship between the contractor (principal), the project owner (obligee), and the surety company. Before issuing the bond, the surety conducts an exhaustive evaluation of the contractor's financial health, management capabilities, and track record of completed projects. This prequalification process effectively filters out financially unstable or inexperienced contractors before they can take on work they cannot handle.

If the contractor defaults, the surety does not simply write a cheque. Performance bonds are "on default" instruments, meaning the surety investigates whether a genuine default has occurred and whether the obligee has met its own contractual obligations. If the claim is valid, the surety has several options: arrange for the original contractor to complete the work, hire a replacement contractor, or provide financial compensation up to the full bond amount. The key point is that the project owner ends up with a completed project built to the original contract specifications.

Letters of Credit: A Bank Payment Promise

A letter of credit (LOC) is a commitment from the contractor's bank to pay the project owner a specified amount when compliant documents are presented. That is it. The bank does not evaluate the contractor's ability to complete the project, does not monitor progress, and does not investigate whether a claim is legitimate.

Letters of credit are "on demand" instruments. When the beneficiary presents the required documentation, the bank pays — regardless of whether the contractor actually defaulted, whether the owner met its own obligations, or whether the claim has any merit. The bank's only job is to verify that the paperwork matches the terms of the credit agreement.

Five Critical Differences

1. Coverage Amount

This is the difference that surprises most contractors. A performance bond typically covers 100% of the contract value for both project completion and, when paired with a labour and material payment bond, payment to subcontractors and suppliers.

A letter of credit is generally issued for just 5% to 10% of the contract value. It gives the owner some cash to work with if problems arise, but it does not come close to covering the cost of completing the project with a new contractor.

2. Impact on Borrowing Capacity

When you obtain a performance bond, it counts against your total surety bonding facility — not your bank credit. Your operating lines, equipment financing, and revolving credit remain fully available. The bond premium is a project cost, not a lien on your assets.

When you post a letter of credit, the bank restricts equivalent cash or draws against your existing credit line. A $500,000 LOC means $500,000 you cannot use for materials, equipment, payroll, or the next opportunity that comes along. Those funds typically remain restricted through the warranty period following project completion, which can add a year or more beyond the construction timeline.

For contractors running multiple projects simultaneously, this distinction is the one that matters most. We regularly see contractors who chose LOCs on two or three jobs discover they cannot access the credit they need when a fourth project comes along.

3. Claims Investigation

With a performance bond, the surety investigates every claim. It verifies that the contractor actually defaulted, confirms the obligee has met its own obligations, and identifies whether alternative solutions exist. This process protects the contractor from frivolous or exaggerated claims. The Surety Association of Canada highlights this as a fundamental advantage: surety bonds support the fairness of the underlying contract by requiring owners to demonstrate that a default has genuinely occurred.

With a letter of credit, there is no investigation. The bank verifies that the documents are compliant and processes the payment. The contractor's only recourse is to pursue the matter through litigation after the money has already been paid out.

4. Project Completion

A performance bond obligates the surety to ensure the project is completed according to the original contract terms. Whether that means financing the original contractor to finish, bringing in a replacement, or negotiating a settlement with the owner, the end result is a completed project.

A letter of credit provides money — typically a fraction of the contract value — but no completion guarantee. The project owner receives cash and must figure out on their own how to get the work finished, often at a significant premium since replacement contractors know they have leverage.

5. Ongoing Monitoring

Surety companies monitor the contractor's entire work program throughout the project. This ongoing oversight often catches problems early, before they escalate into defaults. The surety has a financial incentive to help resolve issues — providing technical support, helping source replacement subcontractors, or mediating disputes — because preventing a claim is far less expensive than paying one.

Banks issuing letters of credit have no involvement in project execution. They do not visit job sites, review progress, or intervene when problems develop.

Cost Comparison

Performance Bond Premiums

In Canada, performance bond premiums typically range from 0.5% to 1.5% of the contract price, inclusive of HST. The exact rate depends on the contractor's financial strength, experience, and the project's risk profile. Contractors with strong financial statements, a solid track record, and projects within their demonstrated capabilities tend toward the lower end.

Where the contract extends beyond one year, renewal premiums apply at each anniversary based on the value of uncompleted work. A 24-month maintenance period typically adds $1.50 to $2.00 per $1,000 of the bond amount.

Letter of Credit Fees

LOC fees are layered and ongoing. Issuance fees, commitment fees, and utilization fees can combine to total 0.75% to 2% or more of the LOC amount annually. Standby letters of credit — the type most commonly used in construction — often run 2% to 3% per year.

Beyond the direct fees, the real cost of a letter of credit is the opportunity cost of restricted capital. Cash or credit tied up in an LOC cannot be deployed for materials, equipment, hiring, or bidding on new work.

Ontario's Legal Requirements

Ontario's Construction Act makes this decision straightforward for public projects. Section 85.1 and section 12 of the General Regulation require both a performance bond and a labour and material payment bond on all public contracts valued at $500,000 or more. These bonds must provide coverage of at least 50% of the contract price using the prescribed Form 32.

This requirement exists because you cannot register a construction lien against Crown property. The bonding requirement replaces lien rights with bond claim rights, ensuring subcontractors and suppliers have a path to payment even when traditional lien remedies are unavailable.

For private construction projects, bonding is not legally mandated but is frequently required by project owners, lenders, or general contractors as a condition of the contract.

When a Letter of Credit Makes Sense

Despite the advantages of performance bonds for construction, letters of credit do have legitimate applications:

• International trade and cross-border supply agreements where the parties need a universally recognized payment mechanism
• Short-term transactions with a defined payment trigger and minimal performance risk
• Situations where the beneficiary specifically requires on-demand access to funds without a claims investigation process
• Non-construction financial obligations such as lease guarantees, import/export transactions, or regulatory deposits

For domestic construction projects in Ontario, these situations are uncommon. The vast majority of contractors we work with are better served by performance bonds.

When a Performance Bond Is the Clear Choice

Performance bonds make the most sense when:

• The project is a public contract subject to Ontario's Construction Act bonding requirements
• Project completion — not just cash — is what the owner needs guaranteed
• You are managing multiple projects and cannot afford to have borrowing capacity restricted
• The contract may change scope, timeline, or value during execution
• You want the surety's ongoing risk management support and early problem intervention
• Subcontractors and suppliers need payment protection through a companion labour and material bond

How to Get Bonded

The surety underwriting process evaluates what the industry calls the three C's: character, capacity, and capital. Your surety broker will guide you through preparing:

• CPA-prepared financial statements — reviewed or audited depending on the bonding facility you need
• Work-in-progress schedule — showing current and upcoming project commitments
• Company resume — demonstrating relevant project experience and completion history
• Personal financial statements — for the company's principals who will provide indemnity
• Banking references and credit history

Contractors with clean financials, a track record of completing projects on time, and projects that match their demonstrated experience typically qualify for competitive bond rates. If you are new to bonding, starting with smaller bid bonds through our Express Bid program can help you build a bonding relationship and establish a track record with the surety.

The Bottom Line

Performance bonds and letters of credit are not interchangeable. One guarantees project completion, protects your borrowing capacity, and includes a built-in investigation process that shields you from invalid claims. The other restricts your cash, covers a fraction of the contract, and pays out on demand without verifying whether the claim is legitimate.

For Ontario contractors, the choice is usually clear. If your project involves construction, if you need to preserve working capital, or if Ontario law requires bonding, a performance bond is the right instrument.

If you are unsure which option fits your next project — or if you are currently using letters of credit and want to explore switching to bonds — contact our surety team for a no-obligation review of your bonding capacity. We will walk you through the real numbers and help you make the choice that protects both your project and your balance sheet.

This article is for general information only. Consult your surety broker and legal counsel for advice specific to your project and circumstances.