Contingency Reserve

A contingency is an addition to the cost breakdown, usually based on a percentage of the hard costs, to be used to fund changes during the build.  For example, the borrower decides half way through the build that rather than granite tile, they want granite slab in the kitchen.  They can either pay that out of pocket, or if they have a contingency reserve, that will fund the difference.  The money for changes cannot be shifted from one line item to another.  Historically, some banks have required a contingency reserve.  Currently, a contingency reserve is allowed, but generally not required on all of our construction loan programs.  Even when a contingency is desired, sometimes there is not room in the deal based on loan-to-cost calculations or the loan amounts for which the borrower can qualify.  Program # 4 allows for a cost plus contract (as opposed to fixed price), and in this case does require a contingency.  A contingency reserve may also be required if the borrower will be their own general contractor.  This is possible if one of the borrowers is a GC, they make their living from job income (not capital gains on real estate), and it is clear from the circumstances that they are building their own house and not trying to get cheap spec money.  Contingencies are usually 5 or 10% of the hard construction costs if used.

Interest Reserve Accounts

An interest reserve account is another line item in the cost breakdown that is used to pay interest during the construction period.  A construction loan with an interest reserve account essentially 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 construction loan amount.  It is usually assumed that more money will be disbursed in the early parts of the build rather than linearly throughout construction.  With these parameters, total expected interest can be estimated, and an interest reserve amount can be added to the cost breakdown.

An interest reserve account would make no sense if a borrower is already maxed out on their loan amount either due to income qualifying, loan to cost or loan-to-value calculations.  For example, let’s say the construction loan is $400,000, total costs are $500,000, and the property is appraising for $500,000 (if completed already as planned).  Assume for illustration purposes maximum loan-to-cost of 80%, lot value of $200,000, construction costs of $300,000 and lot loan balance of $100,000.  The borrower here could get a $400,000 loan because they have 20% equity ($100,000) in the lot.  To close escrow, they would have to bring in closing costs since there is no room to roll them into the loan, but everything else would be covered.  Now let’s say interest is estimated to be $11,250 based on an average loan balance of $300,000 during 9 months of construction at 5.0%.  Total costs would now be $511,500 because $11,500 would be added as another line item to the $300,000 cost breakdown.  Since construction loans are based on 80% of the lesser of total costs or appraised value, the maximum loan amount is still $400,000, and the borrower would now have to bring in closing costs plus $11,500 to close escrow, essentially prepaying interest up front rather than getting a bill monthly.  This would make no sense. 

When there is room in the deal to allow for an interest reserve account, interest is charged and disbursed monthly based on average daily balances during the previous month.  You then pay interest on the interest, but if your interest reserve account is $20,000 for example, you are not paying interest on any part of that $20,000 until it is used.  This works the same way as other line items.  If cabinets were $20,000, you wouldn’t be paying interest on that $20,000 until cabinets were installed and that money was part of a draw.  The only difference between these $20,000 line items is that the $20,000 for cabinets would probably be disbursed all at once, whereas a portion of the $20,000 for interest reserve gets disbursed each month.  Partial interest reserve accounts are OK.  You would just begin getting a monthly bill when the money ran out.  Interest reserves are optional.