What Is Interest Reserve in a Construction Loan?

March 21, 2024

The interest reserve is a key component of construction loans that provides financial stability and relieves the burden of interest payments from the borrower’s cash flow. However, it is important for lenders and borrowers to understand the importance of the interest reserve, accurately calculate and manage it, and address potential challenges that arise throughout the process.

To determine the amount of the interest reserve, the lender typically calculates the total anticipated interest cost based on several factors, including the loan amount, the rate, and the duration of the construction period. Then, the lender adds this amount to the loan, which is then disbursed gradually over the construction phase as interest payments are made.

It is also common for the interest reserve to be seeded at a certain percentage of the loan’s total cost (e.g., 50%), which is based on the assumption that on average only half of the loan will be outstanding at any given time during the construction period. This can help mitigate the risk of an interest reserve shortfall and provide a buffer against construction delays.

One challenge is that if the interest reserve is under-allocated, it may be difficult for the borrower to cover their interest expenses until the loan is fully disbursed. The best practice is to have clear communication with your lender to ensure that the allocated interest reserve is used according to the terms of the agreement. Additionally, both the borrower and lender should monitor the usage of interest reserves on a regular basis to prevent unauthorized expenditures.

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