What is an interest reserve in real estate finance?

What is an Interest Reserve?

An interest reserve is a portion of a construction loan set aside to cover interest payments during the development phase. This reserve is calculated based on the construction duration, loan amount, and interest rate, and is included in the total loan. It allows borrowers to manage cash flow by using the reserve to pay interest until the project generates income.

Interest Reserve Calculation Example

Here's an example of how an interest reserve might be calculated for a real estate construction project:

1. Loan Amount: Suppose the total loan amount for the construction is $1,000,000.
2. Interest Rate: Assume the annual interest rate on the loan is 6%.
3. Construction Period: Let's say the expected construction period is 12 months.

Now, to calculate the interest reserve:

• First, calculate the annual interest: 6% of $1,000,000 = 0.06 * $1,000,000 = $60,000.
• Since the construction period is 12 months (one year), the total interest for the construction period would be $60,000.
• Therefore, the interest reserve needed would be $60,000 to cover the interest payments for the duration of the construction.

In this example, the interest reserve of $60,000 would be part of the total loan amount, and it would be used to make monthly interest payments of $5,000 ($60,000 / 12 months) during the construction phase.