By Jane Meggitt 

When you take out a construction loan, you may find an interest reserve fund included as a line item. While interest reserves are optional in such loans, they are often used by borrowers who like to hang on to their cash. The purpose of such reserves is to pay the estimated costs of interest during the construction period without the borrower having to come up with a monthly interest payment. 

What Is Interest Reserve?

First, consider that construction loans are short-term, usually a year or two while the house is being built. The loan is funded incrementally as construction proceeds. Because the borrower pays interest only on the actual balance, as work progresses, interest charges grow. Interest rates are higher on construction loans than conventional mortgages, because construction carries more inherent risk. 

In a worst-case scenario, something goes awry, and the home is not completed. If a lender must foreclose on the loan, it must usually take on the burden of completing the dwelling, since few people will buy a partially constructed house. If the construction loan doesn’t include an interest reserve, the risk increases. That’s because if a default occurs, the lender will not only have to pay for completing the house, but must also foot the bill for the interest charges. 

With a construction loan, funds known as “the draw” are dispensed on a monthly basis to pay the contractor and suppliers. As the draw funds are dispersed, the construction loan accrues interest, and this interest requires payment. Depending on how the loan is structured, the interest reserve pays either all or a portion of the estimated interest charges during construction. For practical purposes, the interest reserve account on a construction loan uses borrowed money to pay its own interest. 

An Interest Reserve Is Tied to the Draw

With an interest reserve, the borrower pays interest on the interest—but not until the funds are actually used. For example, say your interest reserve account is $25,000. If the installation of custom-made doors on the home costs $10,000, you don’t pay interest on that $10,000 until the custom doors are put in place and the funds are part of a draw. 

Keep in mind that a $10,000 line item for custom doors is generally disbursed at one time, while just part of the $25,000 interest reserve is disbursed monthly. If your interest reserve runs out of money, you then receive a bill each month. 

Calculating Interest Reserve 

Lenders may use several methods to calculate the interest reserve. One of the most common is taking the entire loan value and multiplying it by the interest percentage, then multiplying the months needed to complete construction, times the length of the outstanding loan. Of course, construction rarely goes according to plan, but the approximate interest reserve amount calculated this way should prove sufficient. 

Interest Reserve Risks 

The Federal Deposit Insurance Corporation (FDIC) considers that a major risk with interest reserves is that they may mask a borrower’s inability to repay the loan consistent with the loan terms and obligations. In some instances, an interest reserve can keep a troubled loan current, when in reality, it is not. 

With a mortgage, for example, cash flow issues would soon show up in late or non-payments. Signs of trouble with a construction loan that has an interest reserve may take longer to become apparent. This is another reason lenders will seldom approve a construction loan if the borrower wants to purchase a lot but has no immediate plans to develop it. 

References:

https://www.fdic.gov/regulations/examinations/supervisory/insights/sisum08/sisummer08-article3.pdf

https://www.hgexperts.com/expert-witness-articles/construction-lending-industry-standard-practices-applicable-to-construction-loan-litigation-18115

Jane Meggitt’s work has appeared in dozens of publications, including USA Today, The Alternative Daily, nj.com, The Houston Chronicle and The Nest. She is a graduate of New York University.

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