Interest Reserves for Construction Loans Explained
Quick Answer
An interest reserve is a portion of the construction loan set aside to cover monthly interest payments during the build period. Instead of making monthly payments out of pocket, interest is paid from the reserve. This reduces cash flow pressure during construction.
Table of Contents
How Interest Reserves Work
During construction, the property is not generating income. Rather than requiring the builder to make monthly interest payments out of pocket, lenders establish an interest reserve.
The interest reserve is a designated portion of the loan that covers monthly interest payments automatically. Each month, the accrued interest is deducted from the reserve.
Calculating the Interest Reserve
Interest on construction loans is calculated on the outstanding balance (amount drawn), which increases with each draw.
Example Calculation
- Total loan: $400,000
- Interest rate: 11%
- Construction period: 12 months
- Average outstanding balance: $200,000 (assuming even draw schedule)
Estimated interest: $200,000 x 11% = $22,000/year
A typical lender would establish an interest reserve of approximately $22,000-$25,000 to cover the construction period.
Month-by-Month Example
| Month | Drawn Balance | Monthly Interest |
|---|---|---|
| 1 | $60,000 | $550 |
| 2 | $100,000 | $917 |
| 3 | $150,000 | $1,375 |
| 4 | $200,000 | $1,833 |
| 5 | $250,000 | $2,292 |
| 6 | $300,000 | $2,750 |
| 7 | $320,000 | $2,933 |
| 8 | $340,000 | $3,117 |
| 9 | $360,000 | $3,300 |
| 10 | $380,000 | $3,483 |
| 11 | $390,000 | $3,575 |
| 12 | $400,000 | $3,667 |
| Total | $29,792 |
Impact on Leverage
The interest reserve is part of the total loan amount, which means it affects leverage calculations:
- Without interest reserve: Loan of $375,000 on a $500,000 project = 75% LTC
- With interest reserve: Loan of $400,000 ($375,000 + $25,000 reserve) = 80% LTC
Some lenders calculate leverage excluding the interest reserve, while others include it. Understand your lender's methodology.
Managing the Interest Reserve
- Stay on schedule: Delays increase interest costs and deplete the reserve
- Draw efficiently: Only draw what you need to minimize outstanding balance
- Monitor the reserve: Track remaining reserve against remaining construction time
- Plan for overages: If the project runs long, budget for out-of-pocket interest payments
Related Reading
Key Takeaways
- ✓Interest reserves cover monthly payments during construction
- ✓Interest is calculated on drawn amounts, not total loan
- ✓Project delays deplete the interest reserve faster
- ✓Factor interest reserve into your total project budget