Interest Reserve

An interest reserve is part of a loan budget set aside to pay interest during construction and lease-up. A new building earns no rent while it goes up, so the borrower may have no income for monthly interest payments. With an interest reserve, the lender draws from that budget line each month to pay the interest due. The reserve is usually a line in the construction loan budget, though sometimes the borrower deposits cash in a separate account instead. Some bridge loans on properties being repositioned carry one too.

Lenders size the reserve by projecting interest over the expected building and lease-up period. Because interest is charged only on money drawn, the monthly amount rises as the balance grows. Here is an example with round, hypothetical numbers. A $2,000,000 loan at 10 percent is expected to be about half drawn, on average, over 12 months. Average interest is about $8,333 a month ($1,000,000 × 10% ÷ 12), so the lender books a reserve of about $100,000, plus a cushion for delays or rate changes.

Why it matters for lenders

An interest reserve keeps a loan current, which is exactly why it needs watching. The OCC (Office of the Comptroller of the Currency), which supervises national banks in the US, warns that poorly managed reserves can mask a poorly performing project and have been a major source of bank losses in construction lending. A loan paid from its own reserve looks fine on a delinquency report even when the project is far behind schedule or over budget.

The bigger warning sign is "repacking." When a reserve runs out early because of delays, a lender may add more loan money to refill it. The OCC calls this a red flag for credit problems. It should be a deliberate credit decision, backed by evidence the project still works, not a quiet budget change. Interest paid from the loan also adds to total project cost, so it affects loan-to-cost (LTC) and loan-to-value limits.

How it works in practice

A loan administrator books a $150,000 interest reserve on a retail construction loan. Each month, interest is calculated on the drawn balance, charged to the reserve line, and recorded as paid. The administrator compares the remaining reserve with the months left to completion. At month nine, the project is two months behind and only one month of reserve remains.

She flags the loan for the credit officer, who asks the borrower to deposit cash to cover the gap rather than increasing the loan. When interest reserves are tracked by hand beside a construction draw log, a shortfall like this often surfaces only when the reserve hits zero.