An interest reserve is one of the most important and least understood components of a commercial construction loan. It is the mechanism that keeps your loan current while your project is under construction and not yet producing income. Whether you are building a multifamily property, developing a retail center, or repositioning an office building with a bridge loan, the interest reserve determines how much of your total loan amount goes toward carrying costs rather than bricks and mortar.
This guide explains how interest reserves work on commercial loans, how they are calculated, when lenders require them, and what happens if the reserve runs out before your project is complete. We include calculation examples, comparison charts, and negotiation strategies so you can structure your next deal with confidence.
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What Is an Interest Reserve on a Commercial Loan?
An interest reserve is a portion of a commercial loan set aside in a dedicated account to cover monthly interest payments during the construction or lease-up period. Instead of requiring the borrower to make monthly interest payments out of pocket, the lender holds back part of the total loan proceeds and uses those funds to pay interest charges as they accrue each month.
Think of it as a prepaid interest account. When your lender approves a $5 million construction loan, not all $5 million goes toward building your project. A portion, often 8-15% of the total loan, is earmarked to cover interest payments during the months when your property generates zero income.
The concept exists because construction projects create a cash flow gap. During a 12-18 month build, the property produces no rental income, no sales revenue, and no cash flow. Without an interest reserve, the borrower would need to make monthly payments from personal savings or other business income, which can strain liquidity and increase default risk.
Here is how the basic flow works:
- The lender approves a total loan amount that includes the interest reserve
- At closing or through the initial draw, the interest reserve is funded into a separate account
- Each month, the lender draws from the reserve to cover that month's interest payment
- The loan remains current without requiring out-of-pocket payments from the borrower
- When the project is complete and generating income, the borrower begins making regular payments
The interest reserve is not free money. It is part of your total loan balance, and you pay interest on those funds just as you do on the construction proceeds. This creates a compounding effect that borrowers need to account for in their project budgets.
According to the FDIC, interest reserves are a risk management tool that benefits both parties in a construction lending relationship by ensuring loan payments remain current throughout the development period (source: FDIC Supervisory Insights, "A Primer on the Use of Interest Reserves").
How Do You Calculate an Interest Reserve?
The standard formula for calculating an interest reserve on a commercial construction loan is:
Interest Reserve = (50% x Loan Amount x Interest Rate / 12) x Number of Months
The 50% factor is the key to understanding this formula. Unlike a permanent loan where the full balance is disbursed on day one, construction loans disburse funds gradually through a draw schedule. Early in the project, only a small fraction of the loan is outstanding. By the end, the full amount has been drawn. On average, approximately 50% of the total loan amount is outstanding at any given time.
Example: $4,000,000 Construction Loan
- Total loan amount (before interest reserve): $4,000,000
- Interest rate: 9.0% (SOFR + 4.5% spread)
- Construction period: 14 months
- Average outstanding balance: $4,000,000 x 50% = $2,000,000
- Monthly interest cost: $2,000,000 x 0.75% = $15,000
- Total interest reserve: $15,000 x 14 months = $210,000
The total loan package would be $4,210,000, with $4,000,000 for construction and $210,000 in the interest reserve.
Example: $8,500,000 Multifamily Project
- Construction costs: $8,500,000
- Interest rate: 8.5%, construction period: 18 months, lease-up: 6 months
- Average outstanding balance factor: 55% (front-loaded draw schedule)
- Average outstanding balance: $8,500,000 x 55% = $4,675,000
- Monthly interest: $4,675,000 x (8.5% / 12) = $33,114
- Total interest reserve: $33,114 x 24 months = $794,738
The interest reserve on this project represents about 9.3% of construction costs. On projects with longer timelines or higher rates, the reserve can exceed 12-15% of the base loan.
Some lenders use a 55-65% average balance factor when the draw schedule is front-loaded with land acquisition and sitework. To model your own scenarios, use our commercial mortgage calculator.
Is an Interest Reserve Required on All Construction Loans?
No, but it is standard practice on most commercial construction projects. Whether a lender requires one depends on the loan type, property use, borrower profile, and deal structure.
When interest reserves are almost always required:
Ground-up construction loans for commercial properties nearly always include an interest reserve. The property has no existing income, and the construction period typically runs 12-24 months.
Major renovation and repositioning projects funded through bridge loans often require interest reserves, especially when the renovation displaces existing tenants and eliminates cash flow.
Lease-up periods following construction may also be covered. Even after the building is complete, it takes 3-12 months to secure tenants and stabilize. Many lenders extend the reserve to cover this gap.
When interest reserves may not be required:
Stabilized property renovations where the property continues generating sufficient income may not need a dedicated reserve. If the DSCR remains above 1.0x during renovations, the property's own cash flow can service the debt.
Borrower-funded interest payments are sometimes negotiated on smaller loans or with borrowers who have substantial liquidity.
The OCC has issued guidance indicating that lenders should carefully evaluate the sizing of interest reserves, noting that inadequate reserves can mask credit quality issues while excessive reserves inflate loan balances (source: OCC Comptroller's Handbook, "Commercial Real Estate Lending").
What Happens When the Interest Reserve Runs Out?
When an interest reserve is depleted before the project is complete, the borrower faces a serious cash flow challenge. This typically arises from construction delays, cost overruns, or interest rate increases on floating-rate loans.
Option 1: Budget Line Item Reallocation
If other line items in the construction budget have surplus funds, the lender may allow reallocation to the interest reserve. For example, if framing came in $50,000 under budget, those savings could cover additional months of interest. This requires written lender approval and assumes other categories are not already strained.
Option 2: Borrower Funds the Difference Out of Pocket
The most common outcome. On an $8 million construction loan at 9% that is 85% drawn, the monthly interest payment is approximately $51,000, a substantial outlay most borrowers have not budgeted for.
Option 3: Loan Modification or Increase
The most difficult path. A depleted reserve is a red flag, signaling problems with the budget, timeline, or management. Lenders may require additional collateral or concessions before agreeing.
Experienced developers build a 5-10% contingency buffer into their reserve calculations. For related strategies, see our commercial loan closing costs breakdown.
Can You Negotiate the Interest Reserve on a Construction Loan?
Yes, the interest reserve is negotiable. Experienced borrowers often negotiate its size, structure, and funding mechanism.
Reserve duration: Lenders typically size the reserve for the full construction period plus 3-6 months of lease-up. With pre-leasing commitments, you may reduce the post-construction coverage. Shortening from 18 to 14 months on a large project saves hundreds of thousands.
Average balance factor: If your project has a back-loaded draw schedule, argue for a 40-45% factor instead of 50%, which reduces the reserve.
Rate assumptions: On floating-rate loans, lenders add a 50-150 basis point buffer. Negotiating a smaller buffer meaningfully reduces the reserve.
Funded vs. unfunded: Some lenders allow partial funding, where the borrower covers any shortfall out of pocket. This reduces the total loan amount but requires maintaining liquidity throughout the project.
Need help structuring a competitive construction loan? Contact our team for a free consultation.
How Does an Interest Reserve Affect Your Total Loan Amount?
The interest reserve directly increases your total loan amount, with cascading effects on your project's financial structure.
Without Interest Reserve:
- Land: $1,200,000 / Hard costs: $3,500,000 / Soft costs: $450,000 / Contingency: $257,500
- Total project cost: $5,407,500
- Loan amount (75% LTC): $4,055,625
With Interest Reserve:
- Same project costs: $5,407,500
- Interest reserve (14 months at 8.5%): $240,827
- Total loan amount: $4,296,452
- Effective LTC: 79.5%
The reserve added $241,000 to the loan balance, increasing the effective LTC by 4.5 percentage points. This matters because lenders set maximum LTC limits (typically 75-80%), and the interest reserve eats into your available leverage.
Because you pay interest on the reserve itself, there is a compounding cost. On a $300,000 reserve at 9% over 14 months, the additional interest from compounding is approximately $15,750. For more on total loan costs and exit strategy, see our guide on balloon payments in commercial loans.
What Is the Difference Between Funded and Unfunded Interest Reserves?
The distinction affects your closing costs, liquidity requirements, and total borrowing costs.
Funded Interest Reserves
Included in the total loan amount and disbursed into a dedicated account at closing. The lender draws from it monthly.
- Full reserve is part of the loan balance from day one
- Interest accrues on reserve funds immediately
- No monthly out-of-pocket payments required
- Higher total loan amount and associated fees
- Most common structure on commercial construction loans
Unfunded Interest Reserves
The borrower commits to covering interest payments as they come due, without funds set aside.
- Lower total loan amount
- No interest-on-interest compounding
- Monthly cash outlay during construction
- Requires significant borrower liquidity
- More common on smaller projects or with high-net-worth borrowers
Hybrid Structures
Some lenders offer hybrids where a portion is funded (say, 6 months) and the borrower covers the remainder. Another variation is "pay-as-you-go," where interest costs are included in each monthly draw request rather than pre-funded.
Most commercial borrowers prefer funded reserves because they eliminate the burden of monthly payments during construction. If you have strong cash flow from other properties and want to minimize your balance, an unfunded or hybrid structure can save money.
How Do Interest Rates Affect Your Interest Reserve?
Most commercial construction loans carry floating rates tied to SOFR or Prime plus a lender spread. Your actual monthly interest cost fluctuates, creating uncertainty about whether the reserve will last.
Rate Increase Scenario
A $6,000,000 construction loan at 8.5% with a 16-month term:
- Original monthly interest (50% average draw): $21,250
- Original total reserve: $340,000
- If rates increase 100 bps to 9.5% at month 6: new monthly interest is $23,750
- Additional cost over remaining 10 months: $25,000
- Reserve shortfall: approximately $25,000
A 1% rate increase burns through the reserve about 7% faster. Strategies to manage rate risk include purchasing interest rate caps, negotiating rate lock periods, requesting a larger reserve upfront, and monitoring rate movements monthly.
For more on how vertical construction loans handle rate protections, see our development specialty programs.
What Are Common Mistakes Borrowers Make with Interest Reserves?
Underestimating the construction timeline. A 14-month project stretching to 20 months needs 43% more interest coverage. Always build a 2-3 month buffer.
Ignoring the lease-up period. Most commercial properties need 3-12 months to stabilize after construction. If your reserve only covers the build, you face out-of-pocket payments when you need cash for tenant improvements.
Forgetting about interest on the reserve. The reserve is part of your loan balance. Borrowers who exclude it from their calculations end up short.
Not accounting for rate increases. On floating-rate construction loans, a 150 basis point rate increase over the build period can add 15-20% to your total interest costs. Always stress-test your reserve against a scenario where rates climb 100-200 basis points during construction.
Failing to monitor draw pacing. If your construction draws are front-loaded (land purchase, site prep, foundation work), the average outstanding balance will be higher than the typical 50% assumption, which leads to faster reserve depletion than originally projected.
How Do Different Loan Types Handle Interest Reserves?
Construction loans almost always include a funded interest reserve sized for the full build plus 3-6 months of lease-up. For ground-up construction, expect 8-15% of the base loan.
Bridge loans frequently include reserves when renovations disrupt cash flow. Reserves tend to be smaller (6-12 months) because existing income provides a baseline. Bridge loan programs at Clearhouse offer flexible reserve options.
SBA loans allow interest reserves as part of the total project cost, with specific guidelines on calculation and what costs qualify.
Hard money loans almost always require funded reserves due to higher rates (10-14%). Some hard money lenders require borrower-funded reserves from personal funds.
CMBS loans for stabilized properties typically do not include interest reserves since the property is already generating income.
Contact Clearhouse Lending to discuss which loan structure and interest reserve option fits your commercial project.
What Should You Know Before Signing a Loan with an Interest Reserve?
Is the interest reserve tax deductible?
Interest paid from a reserve account is generally deductible as a business expense in the year it is paid. However, for properties under construction, the IRS may require capitalization under Section 263A. Consult your tax advisor.
Can the interest reserve be refunded if the project finishes early?
Unused funds are typically applied to reduce your outstanding loan principal, not refunded as cash. This lowers your balance going into permanent financing and can improve your DSCR.
Does the reserve earn interest while in the account?
In most cases, no. The reserve is held in a non-interest-bearing account. Negotiating an interest-bearing escrow is uncommon and yields minimal returns relative to project costs.
What is a typical reserve for a 12-month construction project?
At 8-9% interest, the reserve typically ranges from 4-6% of the base loan amount. On a $5,000,000 loan at 8.5% for 12 months, the reserve would be approximately $212,500, or 4.25% of the loan.
Can you use personal funds instead of a loan-funded reserve?
Yes. This keeps the loan balance lower and reduces total interest costs, but requires depositing the full reserve amount into a lender-controlled account at closing.
What happens to the reserve when the loan matures?
Remaining funds are applied to the outstanding principal. If the reserve is depleted and the project is not generating income, the borrower must pay off the loan, negotiate an extension, or face default.
Have questions about interest reserves or construction financing? Schedule a consultation with Clearhouse Lending to discuss your project and get expert guidance.
Clearhouse Lending arranges commercial construction loans, bridge loans, and permanent financing nationwide. Our team structures interest reserves and loan terms to match your project timeline and budget. Contact us today to get started on your next commercial project.