Construction loan interest reserve: what it is and how to size it
An interest reserve is the part of a construction loan set aside to pay the loan's own interest until the project is sold or refinanced. You size it by projecting the drawn balance month by month and adding up the interest: on $10,000,000 of construction costs drawn over 18 months at 7.5%, that is $546,038 if the loan is repaid at completion and $1,364,754 with a 12-month lease-up.
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Why a construction loan pays its own interest
A building under construction earns nothing, so there is no income to pay interest from. Instead the lender funds the interest out of the loan itself: each month's interest is drawn from the reserve and added to the balance. The borrower's cash goes into the equity and the work, and the reserve covers the carry until the sale or a permanent loan repays everything.
How to size it
- Start from the draw schedule: how much of the loan is drawn each month. Spending usually follows an S-curve, slow at the start and heaviest mid-build.
- Each month, charge the yearly rate divided by 12 on the balance drawn so far, interest included. The construction loan interest calculator does this for any loan.
- Keep going through lease-up until the month the loan is repaid.
- The sum is the reserve. Because the reserve is part of the loan and the loan is sized on total cost, a bigger reserve makes the loan bigger too; the free pro forma solves that loop exactly.
How rate and lease-up change it
Interest reserve on $10,000,000 of construction costs drawn over an 18-month build on an S-curve. The loan covers the costs and the reserve together; brackets show the reserve as a share of the costs.
| Rate | Repaid at completion | 6-month lease-up | 12-month lease-up |
|---|---|---|---|
| 6% | $434,430 (4.3%) | $751,402 (7.5%) | $1,078,002 (10.8%) |
| 7.5% | $546,038 (5.5%) | $947,746 (9.5%) | $1,364,754 (13.6%) |
| 9% | $658,874 (6.6%) | $1,147,607 (11.5%) | $1,658,749 (16.6%) |
Lease-up moves the reserve more than the rate does. At 7.5%, going from no lease-up to 12 months adds $818,716; a rate 1.5 points higher with no lease-up adds $112,836. By the end of construction all the costs are drawn, so each month of lease-up charges interest on all of them, plus the interest added so far.
In a full pro forma
In the sample pro forma, equity pays for the land and the first months of construction, so the loan is drawn later than in the table above. Its 65% loan at 7.5% over an 18-month build and 9-month lease-up carries $918,230 of interest, 9.5% of the loan. Equity going in first is one of the simplest ways to shrink the reserve.
When the reserve runs short
A reserve sized on a 9-month lease-up runs out if leasing takes 15. From then on interest is paid in cash, unless the lender agrees to rebalance the budget, typically by moving contingency or calling more equity. Track the reserve as its own budget line, the way the construction budget template tracks financing and interest, so a slow lease-up shows up in the forecast before it shows up in the bank account.
Questions
What is an interest reserve on a construction loan?
Part of the loan set aside to pay the loan's own interest while the project is built and leased up. Each month the interest is paid from the reserve and added to the balance, so the borrower does not pay it in cash.
How does interest on a construction loan work?
It is charged monthly on the amount drawn so far, not on the full loan, so it starts small and grows with every draw. With an interest reserve it is paid from the loan itself and added to the balance; otherwise it is paid in cash each month.
How is an interest reserve calculated?
By projecting the loan balance month by month from the draw schedule and charging the rate on it until the loan is repaid. The sum of that interest is the reserve. Rules of thumb that assume an average balance skip the timing that decides most of the answer.
Is the interest reserve part of total development cost?
Yes. It is a financing cost, and lenders size the loan on total cost including it. In the sample pro forma, interest is $918,230 of the $14,848,230 total.
What happens when the interest reserve runs out?
Interest has to be paid in cash from then on, unless the lender agrees to rebalance the budget, usually by moving contingency or adding equity. A longer lease-up than planned is one way it happens, because the whole loan is drawn by then.