What is an interest reserve?

How does an interest reserve work?

The reserve is a budget category inside the loan. Each month the lender or servicer calculates interest on the outstanding balance and funds that payment out of the reserve line. The payment increases the loan balance the same way a hard-cost draw does, so the borrower pays interest on the interest that the reserve has funded.

Because the reserve is part of the loan amount, it is also part of total project cost. That matters for proceeds. A larger reserve raises the loan request and the cost basis together, which moves the loan-to-cost ratio and can push the request past the lender's limit even when the construction budget itself has not changed.

Once the reserve is spent, interest becomes a borrower obligation. Most loan agreements also let the lender require the borrower to rebalance the budget if the remaining reserve looks too small to reach completion or stabilization.

Worked example: sizing a reserve

In this hypothetical example, the loan funds $10,800,000 of project costs in 12 equal monthly draws, followed by 6 months of lease-up with the full balance outstanding. Interest accrues monthly at a hypothetical 8.00% and is paid from the reserve, so each interest payment is added to the balance. The inputs are illustrative only and are not a rate quote.

A shortcut some sponsors use is half the cost draws times the annual rate for the build period, which gives $432,000 here. That shortcut misses compounding and the entire lease-up period, so it would leave the project less than half funded against the modeled need.

The stress row shows why lenders ask for a rate case on floating-rate loans. A hypothetical 1.00% increase adds $122,871 of interest, which someone has to fund if the reserve was sized only to the base case.

Monthly interest = (prior balance + current draw + prior interest funded) x annual rate / 12

What do lenders look for in an interest reserve?

• A monthly model tied to the construction schedule and the draw curve, with a separate lease-up period
• A rate assumption that reflects the loan index, such as SOFR plus the spread, with a stress case
• Whether an interest rate cap limits the rate the reserve has to carry
• Operating income expected during lease-up and how much of it the lender will count
• Who funds a shortfall, and whether the guarantor's liquidity actually supports that obligation

Why an undersized reserve causes problems later

A thin reserve rarely shows up as a problem at closing. It shows up 14 or 16 months later, when the building is late or leasing is slow and the lender stops funding interest. At that point the sponsor needs fresh equity, a loan modification, or a guarantor payment, and each of those is harder to negotiate on a stalled project.

Lenders reviewing a request compare the reserve against the draw schedule and the takeout timing. A reserve that ends before the permanent lender will refinance is a gap in the plan. Our construction underwriting guide covers how the reserve fits with contingency, equity, and completion tests.

Capital Partners reviews the reserve model before a construction loan request goes out, because re-cutting it after a lender issues terms costs time. If the budget and schedule are ready, submit the deal for a principal to review.

Common questions