How Do Surety Bonds Work?
Financial terms may seem quite daunting to those who have not yet acquainted themselves with the various concepts involving finance. Rather than just ignoring them until you find yourself associated in legal agreements with other parties, it is necessary to educate yourself on these terms as early as possible. Surety bonds, for example, are one of the more common terms that you come across in legal transactions.
Before understanding what a surety is, it is vital to first understand the concept of a bond. Bonds are legally binding agreements made between two or more entities. Stocks are a different concept entirely. More people normally consider bonds as a means of investing money to be less risky than stocks.
For example, imagine an established corporation that has plans on expanding. Perhaps this corporation has to buy another factory to increase its production and that factory might be worth one million dollars. However, they do not have the one million dollars to purchase the factory.
One thing it could do is to borrow the money by issuing bonds. Since these are fluid entities, many people can purchase bonds. The company could offer bonds worth ten thousand dollars at face value and if at least one hundred people purchase a bond by lending this amount, then the company would have enough money to buy the factory it needed for expanding.
In exchange, the company promises its lenders a ten percent interest to be paid annually. Regardless of whether or not the new factory serves the company well, the interest has to be paid because it is considered a company expense. This is where bonds diverge from stocks.
Stocks may greatly increase or decrease in value depending on how the market does, but interest rates that come with bonds stay put. Although the lenders are unable to get astoundingly big returns if a business does well, they are still protecting themselves from the danger of a business going bankrupt. Nevertheless, they still acquire the interest rate that was agreed upon by both parties.
They also get a guarantee that they get the principal amount they contributed once the bond has reached its maturity or the date the company has promised that they get the entire principal value they initially paid, which in this case, is ten thousand dollars. Of course, bonds do not come without their own risks. Private corporations that issue them often come with a larger risk than government bodies issuing bonds because corporations carry with them the risk of going bankrupt.
This is the reason why private entities commonly offer generous interest rates as a means of attracting more lenders. However, if a private business declares bankruptcy, the lenders lose their money altogether. This is when sureties come in to play.
A surety is often referred to as a risk transfer mechanism. The lender could employ the use of a surety in the form of an insurance company. A surety, in this case, is a financial guarantee to the lender that if the company fails to meet its obligations or pay its dues, the lenders can still get the principal amount they initially paid. The financial guarantee will be offered by the insurance company on behalf of the corporation that promised to return the loans to its lenders. A surety bond is more commonly used in licensing agreements, but this is just to explain the general idea behind them. Educating yourself financially may seem like such a hassle, but you will be wiser for it in the future in terms of handling your hard earned money.
Before understanding what a surety is, it is vital to first understand the concept of a bond. Bonds are legally binding agreements made between two or more entities. Stocks are a different concept entirely. More people normally consider bonds as a means of investing money to be less risky than stocks.
For example, imagine an established corporation that has plans on expanding. Perhaps this corporation has to buy another factory to increase its production and that factory might be worth one million dollars. However, they do not have the one million dollars to purchase the factory.
One thing it could do is to borrow the money by issuing bonds. Since these are fluid entities, many people can purchase bonds. The company could offer bonds worth ten thousand dollars at face value and if at least one hundred people purchase a bond by lending this amount, then the company would have enough money to buy the factory it needed for expanding.
In exchange, the company promises its lenders a ten percent interest to be paid annually. Regardless of whether or not the new factory serves the company well, the interest has to be paid because it is considered a company expense. This is where bonds diverge from stocks.
Stocks may greatly increase or decrease in value depending on how the market does, but interest rates that come with bonds stay put. Although the lenders are unable to get astoundingly big returns if a business does well, they are still protecting themselves from the danger of a business going bankrupt. Nevertheless, they still acquire the interest rate that was agreed upon by both parties.
They also get a guarantee that they get the principal amount they contributed once the bond has reached its maturity or the date the company has promised that they get the entire principal value they initially paid, which in this case, is ten thousand dollars. Of course, bonds do not come without their own risks. Private corporations that issue them often come with a larger risk than government bodies issuing bonds because corporations carry with them the risk of going bankrupt.
This is the reason why private entities commonly offer generous interest rates as a means of attracting more lenders. However, if a private business declares bankruptcy, the lenders lose their money altogether. This is when sureties come in to play.
A surety is often referred to as a risk transfer mechanism. The lender could employ the use of a surety in the form of an insurance company. A surety, in this case, is a financial guarantee to the lender that if the company fails to meet its obligations or pay its dues, the lenders can still get the principal amount they initially paid. The financial guarantee will be offered by the insurance company on behalf of the corporation that promised to return the loans to its lenders. A surety bond is more commonly used in licensing agreements, but this is just to explain the general idea behind them. Educating yourself financially may seem like such a hassle, but you will be wiser for it in the future in terms of handling your hard earned money.
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