The Nuts and Bolts of Construction Financing

There are two ways to finance a home during construction. The first option is for your builder to obtain the financing. Within this approach, the buyer negotiates a contract with the builder to provide a completed dwelling which you will purchase. You will obtain a conventional mortgage and close on the property just as you would an existing home.

The second option is for the buyer to obtain the construction financing. Under this option, you may have to purchase the land as well as pay for construction.

Commonly, lenders will provide up to 80 percent of the total land and construction costs, requiring that 20 percent comes from the buyer's funds. A significant portion of the 20 percent will be used as partial payment on the land. Since the buyer must own the land when construction begins, the land is purchased at the time of closing. Most lenders require the buyer to contribute a minimum of 30 percent of the land purchase price. The remaining 70 percent of the land purchase price is released to the seller from the buyer's construction loan.

Thus, the seller is paid in full for the land at the time of closing, and the buyer will have received the first in a series of disbursements on their loan. The remaining funds will be disbursed throughout the construction process following satisfactory completion of work. Typically, the buyer will pay interest each month on the amount of the loan disbursed to that point. Some lenders set a fixed interest rate during the construction period, but others tie it to an index which fluctuates month to month.

It is a good idea to have a general contractor review the bank's disbursement schedule to ensure that the amounts released for specific segments of work completed meet his/her cash flow needs. Often materials must be paid for in advance; that is one reason the buyer must have some funds of their own to contribute.

Eventually the home will be completed, an occupancy permit issued, and a final inspection conducted by the lender. At this point some construction financing programs allow for the loan to automatically convert to a conventional fully-amortizing mortgage. This automatic conversion saves the buyer the expense of having to obtain another loan to pay off your construction loan. Usually a conversion option is selected from a menu of fixed and adjustable rate possibilities at the time the buyer applies for the construction loan.

Following are a list of useful questions to ask when you are shopping for construction or reconstruction financing: 1) Will the loan automatically convert after the construction phase? 2) What conversion options are available? 3) Does the lender provide a standard disbursement schedule? 4) What percentage of the total cost (land plus construction) does the lender fund? 5) What percentage of the land purchase price does the lender release at closing? 6) How much are property inspection fees? 7) Are there any free inspections? 8) Is there a conversion fee? 9) Do lenders have originators that can explain their construction program?

Home