When developers or business owners secure construction or commercial real estate loans, there is often a gap between loan disbursement and the time the project starts generating income. To bridge this gap, lenders require an interest carry reserve—a predetermined amount of loan funds set aside exclusively for paying interest during this non-income stage.
How the Interest Carry Reserve Works:
- Calculation: The lender estimates the total interest accruing during the expected non-revenue phase, like construction and lease-up.
- Funding: This amount is deducted from the total loan at closing, reducing the immediate cash available for project costs.
- Control and Payments: The reserve is held in a separate account controlled by the lender, who draws from it monthly to pay the loan’s interest.
For example, on a $5 million loan with a 6.5% interest rate and an 18-month construction period, the monthly interest payment would be about $27,083. The total interest carry reserve would be approximately $487,500, set aside to cover interest during that time.
Key Points:
- The reserve protects lenders by guaranteeing interest payments even if the project is delayed or slow to stabilize.
- This reserve is not authorizable for project expenses or contingency; it can only pay loan interest.
- Borrowers effectively pay interest on this reserve since it reduces immediately available funds, impacting overall loan costs.
- If the project stabilizes early, leftover reserve funds typically are applied to the loan principal or returned, depending on the loan agreement.
Understanding the interest carry reserve can help borrowers plan their financing more accurately and avoid surprises during the critical non-income period of construction or development projects.
For further reading on construction financing, you may find our article on Commercial Construction Loan helpful. For understanding loan components better, see Interest Accrual.
References:
- IRS.gov provides guidance on loan interest considerations (https://www.irs.gov/).
- Investopedia’s explanation of interest reserves (https://www.investopedia.com/terms/i/interestreserves.asp)