An interest reserve is money set aside inside a construction loan to pay the loan's interest while the project is being built. Instead of making monthly interest payments out of pocket, the builder's interest is paid from the reserve until construction is complete or the reserve runs out. It usually appears as its own line item in the loan budget.
Key Takeaways:
- What it does: Pays construction loan interest from the loan itself, so the builder keeps cash for the project.
- How it grows: Interest is charged only on funds drawn so far, so monthly interest rises as the build progresses, and payments from the reserve add interest on the interest.
- How to size it: Estimate from the draw schedule, not the full loan amount, then add a buffer for delays.
- The trade-off: It protects cash flow, but it adds to the amount borrowed, and a reserve that runs out means monthly interest bills.
How Does an Interest Reserve Work?
An interest reserve works alongside the draws on residential construction loans.
- Draws fund the build in stages: the lender releases money as each phase is completed, so the loan balance starts small and grows over the term.
- Interest is charged on what's been drawn: early months cost little; the last months cost the most.
- The reserve pays the interest bill: each month the lender takes that month's interest from the reserve instead of billing the builder.
- Interest on the interest: the reserve uses borrowed money to pay its own interest, so each payment adds to the loan balance, and that balance earns interest too.
For how draws are requested and released, see our guide to the construction loan draw process.
Why Do Lenders Use Interest Reserves?
A partly built home is hard to sell, so a lender that takes one back usually has to pay to finish it. A reserve keeps interest current during the build, so missed payments don't add to that risk.
How Do You Calculate Interest Reserve?
The quick method, loan amount times rate times term, assumes the whole loan is outstanding from day one. On a construction loan it isn't, so that method usually overstates the reserve. A better estimate follows the draw schedule: add up each month's interest on the balance drawn so far.
Worked Example: A $1M New Construction Loan
$1,000,000 in construction costs drawn in 12 equal monthly draws, a 10% annual interest rate (for illustration only, not a Builders Capital rate), with interest paid monthly from the reserve.
The draw-based estimate is about $55,900. The quick method would set aside $100,000. The loan balance includes earlier reserve payments.
How Much Buffer Should You Add for Delays?
Delays hit the reserve hardest because they add months at the full loan balance. In the example above, three extra months at the end of the build add about $26,600, taking the total to about $82,500. Size the reserve for a realistic schedule, not the best case, and recheck it whenever the timeline or budget changes.
Pros and Cons of an Interest Reserve
How Does Builders Capital Handle Interest Reserves?
Builders Capital offers interest reserves as part of certain ground-up construction loans and AD&C loans. Rather than requiring an interest reserve on every loan, the approach depends on the financing structure and project.
When an interest reserve is included, funds are set aside within the loan to cover interest as construction progresses. If the reserve is exhausted before the loan is repaid, the borrower may begin making monthly interest payments.
Because construction timelines, draw schedules, and financing needs vary, the interest reserve structure is determined as part of the overall loan.
FAQs About Interest Reserves
Is an Interest Reserve Required on Every Construction Loans?
No. Many lenders offer it as an option, though some require one on longer or higher-risk projects, so check your loan terms.
Is an Interest Reserve Account an Asset?
The reserve is loan money the lender holds and pays out for interest, so it isn't cash the builder can spend elsewhere. How it shows up on your books depends on the loan's structure, so confirm the treatment with your accountant.
Is an Interest Reserve the Same as an Escrow Acount?
No. An escrow (impound) account holds the borrower’s own money to pay property taxes and insurance on a mortgage, while an interest reserve is part of the construction loan, set aside to pay the loan’s interest during the build.
What is the Difference Between an Interest Reserve and a Contingency Reserve?
An interest reserve covers loan interest during construction, while a contingency reserve covers unexpected building costs such as overruns or price changes. See our guide to construction contingency.
