The Nuts and Bolts of ConstructionFinancing

There are two ways to finance a home during construction. The first optionis for your builder to obtain the financing. Within this approach, the buyernegotiates a contract with the builder to provide a completed dwelling whichyou will purchase. You will obtain a conventional mortgage and close onthe 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 forconstruction.

Commonly, lenders will provide up to 80 percent of the total land andconstruction costs, requiring that 20 percent comes from the buyer's funds.A significant portion of the 20 percent will be used as partial paymenton 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 buyerto contribute a minimum of 30 percent of the land purchase price. The remaining70 percent of the land purchase price is released to the seller from thebuyer'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 disbursementson their loan. The remaining funds will be disbursed throughout the constructionprocess following satisfactory completion of work. Typically, the buyerwill pay interest each month on the amount of the loan disbursed to thatpoint. 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 disbursementschedule to ensure that the amounts released for specific segments of workcompleted meet his/her cash flow needs. Often materials must be paid forin advance; that is one reason the buyer must have some funds of their ownto contribute.

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

Following are a list of useful questions to ask when you are shoppingfor construction or reconstruction financing: 1) Will the loan automaticallyconvert after the construction phase? 2) What conversion options are available?3) Does the lender provide a standard disbursement schedule? 4) What percentageof the total cost (land plus construction) does the lender fund? 5) Whatpercentage 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 explaintheir construction program?

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