An interest reserve is a portion of your construction loan set aside to pay the monthly interest during the build, when the property produces no income. It's a budgeted use of funds, so it consumes loan proceeds you'd otherwise spend on construction. Sizing depends on the projected drawn balance over your schedule — and whether the lender charges interest on the drawn balance or the full commitment, which can be a six-figure difference.
Why the reserve exists
A property under construction generates no rent and no sale proceeds. But the loan starts accruing interest at closing.
You could pay that out of pocket monthly. On an $1.8M construction loan at 11%, that's roughly $16,500 a month at full draw — real money coming out of a sponsor's account for 18 months at exactly the time their capital is most committed.
Instead, lenders capitalize it. They budget an interest reserve as a line item in the project cost, fund it with the loan, and draw against it monthly to make the payment. You never write a check. Your monthly statement shows the interest paid from the reserve and the reserve balance declining.
It's clean and it's standard. It's also frequently mis-sized, and the sponsor is the one holding the bag when it is.
The reserve is not free money
This is the part that catches people. The reserve is funded by the loan, and the loan is capped by LTC and LTARV. Every dollar in the reserve is a dollar not available for construction.
Take a project with $2.4M in total costs at 80% LTC:
- Loan: $1,920,000
- Sponsor equity: $480,000
Now suppose the reserve is $190,000 of that $2.4M in uses. Your loan still totals $1,920,000, but $190,000 of it goes to paying yourself's interest, leaving $1,730,000 for land and construction.
If the reserve had been sized at $130,000 instead, you'd have $60,000 more for actual construction. Same loan, different allocation.
And it compounds. Interest accrues on the drawn reserve too — you're borrowing money to pay interest, and paying interest on that borrowing. On a long build, capitalized interest on the reserve itself can run 5–8% of the reserve amount.
Drawn balance vs. full commitment
This is the single largest cost variable in a construction loan and it rarely appears in a rate comparison.
Drawn balance accrual: interest is charged only on funds actually disbursed. Month one you've drawn $600K of a $1.8M commitment, so you pay interest on $600K.
Full commitment accrual: interest is charged on the entire $1.8M from closing, whether disbursed or not.
The math on an 18-month build, $1.8M commitment, 11% rate:
- Drawn balance (average ~55% outstanding) — ~$163,000
- Full commitment — ~$297,000
A $134,000 difference. That's more than a full point of rate — and it doesn't show up if you're comparing "10.5% vs 11%" on two term sheets.
Ask this question on every term sheet: is interest charged on the drawn balance or the committed amount? If the answer is the full commitment, either negotiate it or price it into your comparison.
Some lenders split the difference — drawn balance with a minimum outstanding floor, or a non-use fee of 0.25–0.50% on undrawn funds. That's a reasonable middle ground and much cheaper than full accrual.
How the reserve gets sized
Proper sizing requires projecting your drawn balance month by month against your construction schedule, then applying the rate.
A simplified approach lenders use: average outstanding balance × rate × term, plus a cushion.
For a $1.8M loan at 11% over 18 months with an average outstanding of roughly 55%:
$1,800,000 × 55% × 11% × 1.5 years ≈ $163,000
Add 15–20% cushion for schedule slip and you're at roughly $190,000.
But the average outstanding percentage depends entirely on your draw curve. A project with a large day-one land advance carries a much higher average balance than one with a small land piece and back-loaded construction. Build the actual month-by-month schedule — it takes twenty minutes in Excel and it's the difference between a reserve that works and one that doesn't.
What happens when it runs out
The reserve is sized to a schedule. Construction schedules slip. When the reserve depletes and the project isn't finished:
- You start paying interest out of pocket, monthly, at exactly the moment your capital is most stretched and your project is behind.
- You request a reserve increase. The lender may allow reallocation from contingency or from savings on completed line items — but only if the loan hasn't hit its LTC or LTARV ceiling.
- You bring fresh equity. Often required as a condition of an extension.
- The loan matures unfunded. This is where projects die. The building isn't finished, the reserve is gone, the loan is due, and the sponsor has no leverage in the extension negotiation.
Lenders watch reserve burn closely. A reserve depleting faster than construction is progressing is one of the earliest reliable signals that a project is in trouble, and it changes how the lender treats you on every subsequent draw request.
Sizing it right
Use the honest schedule. If your GC says 14 months, size for 18. Every construction project you have ever been involved in took longer than the schedule said. This one will too.
Model the actual draw curve, not a flat average. Front-loaded land advances change the math substantially.
If the loan is floating rate, stress it. A reserve sized at today's index with a rate that moves 150 basis points against you runs out early. Size at index plus a cushion.
Add extension months. If the loan has two three-month extensions you'll realistically use one, and the reserve should cover it.
Confirm the accrual method before you build the model. Full-commitment accrual roughly doubles your reserve requirement.
Negotiating points
- Drawn-balance accrual. The highest-value item on the list. Push hard.
- Reserve replenishment from contingency savings. Get written flexibility to move unused contingency into the reserve if the schedule slips.
- No minimum interest guarantee. Some lenders require a floor — 6 or 9 months of interest regardless of early payoff. If you might finish and sell in 8 months, a 9-month minimum costs you money for nothing.
- Reserve release at completion. Any unused reserve balance should reduce your payoff, not stay with the lender. Confirm this in writing; it's usually standard but not always.
Questions I Get
Do I pay interest on the interest reserve?
Yes. Reserve draws increase your outstanding balance and accrue interest like any other draw.
Can I skip the reserve and pay interest myself?
Some lenders allow it, and it preserves loan proceeds for construction. It requires you to have the monthly cash, and lenders will verify liquidity before agreeing.
What if I don't use the whole reserve?
Unused reserve is undrawn loan proceeds. It reduces your payoff. You don't owe interest on money you never drew, assuming drawn-balance accrual.
How big should the reserve be?
Commonly 5–10% of the loan amount, but that's a rule of thumb, not a method. Model it from your draw schedule.
Does the reserve count toward loan-to-cost?
Typically yes on both sides. Confirm it — it affects your available construction dollars.
Comparing term sheets? The accrual method and reserve sizing usually matter more to your returns than the headline rate. Hub Financing negotiates these terms before you sign and models the real all-in cost across competing quotes. Compensated by lenders at closing — no fee to borrowers.
Chris Sava Hub Financing, LLC 25L Inn Street, Newburyport, MA 01950
chris@hubfinancing.com | 978-417-9325 | hubfinancing.com