The interest reserve account allows the lender to periodically advance the loan funds to pay interest on the outstanding balance of the loan. Interest is capitalized and added to the loan balance. Construction loans have an interest reserve account from which interest payments are made during the construction period. In most cases, the first loan advance includes an initial deposit in the interest reserve account in an amount sufficient to make loan payments throughout the construction term.
Most of the costs associated with a construction loan are the interest you'll pay during the 12-month construction period. An investor prepays that cost in advance at the time of its construction and keeps it in an interest reserve account. The construction lender analyzes the supply and, according to our formulas, establishes the interest that is likely to accrue during the term of this construction loan. An interest reserve account is another item in the cost breakdown used to pay interest during the construction period.
A construction loan with an interest reserve account basically uses borrowed funds to pay interest on itself. Interest is estimated based on the expected rate during construction, the expected construction period, the loan balance at the beginning, and the final amount of the construction loan. It is generally assumed that more money will be spent in the early parts of the construction, rather than doing so linearly throughout the construction. With these parameters, the total expected interest can be estimated and an interest reserve amount can be added to the cost breakdown.
When the construction lending structure does not include an interest reserve, the risk to the bank increases. Construction loans have a defined “construction period”, which is the amount of time the borrower has to complete the project. This is another reason why lenders rarely approve a construction loan if the borrower wants to buy land but has no immediate plans to develop it. For practical purposes, the interest reserve account on a construction loan uses borrowed money to pay its own interest.
As the lottery funds disperse, the construction loan accrues interest, and this interest must be paid. Each renovation or development has a planned construction period, during which the loan proceeds are disbursed. At the end of the construction period, the loan is due in full or its payments are converted into principal and interest. Most construction loans are closed lines of credit, meaning they start with a zero balance at the time of origination and increase over time.
An interest reserve account would make no sense if the borrower has already exhausted the maximum amount of their loan due to income requirements, the cost of the loan, or calculations of the loan-to-value ratio. Unless you're taking advantage of capital with a line of credit, new buildings require a different type of construction financing than traditional asset purchases. That way, you won't have to pay a check to the bank every month, as interest accrues while the loan balance increases during the construction of the process. The construction period is considered the time during which any physical construction takes place, starting with land clearing or demolition.
To be a successful and profitable developer, no matter your scale, you must understand construction loan options. First, consider that construction loans are short-term, usually one or two years while the house is being built. .