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.