An interest reserve is a financial tool often used in real estate development or construction loans to cover interest payments during the project’s construction phase. Instead of the borrower making regular interest payments out of pocket, a portion of the loan is set aside in a reserve account to pay the interest as it accrues.
This allows the developer to focus on the construction without worrying about servicing the debt until the project generates income, typically once it’s completed, leased, or sold.
Here’s how it works:
- Loan Structure: When a lender agrees to finance a development project, they include an amount in the total loan to cover interest expenses during the construction period.
- No Immediate Payments: Instead of requiring monthly interest payments during construction, the lender draws from the interest reserve to cover these costs.
- Self-Adjusting: As the project progresses, the loan balance increases because the unpaid interest is capitalized, meaning it gets added to the principal balance.
- Transition to Regular Payments: Once the project is complete or reaches stabilization (e.g., occupancy for lease-up projects), the borrower starts making regular payments, including principal and interest, based on the full loan amount.
The interest reserve helps ensure the project has sufficient funding and allows the developer to focus on completing the project without worrying about cash flow to cover interest.