How do you calculate an interest reserve on a construction loan?

For a first estimate, multiply the debt before interest by the average share drawn, the rate and the length of the build in years, then add the months after completion at the full balance. For a budget, build the schedule month by month, adding each month's draw and charging interest on the running balance, including earlier interest. The month-by-month figure comes out higher because the interest itself earns interest and each draw is charged from the day it is made.

What happens when an interest reserve runs out?

Interest is still due, so the shortfall has to be met. The lender's test of whether the remaining money will finish the project usually shows it before the reserve is empty, and funding can stop until the developer or a guarantor puts in cash. The alternatives are cutting scope or asking the lender to increase the limit, which is a fresh credit decision and normally brings a new look at value and feasibility.

Do you pay interest during construction on a development loan?

On most commercial development loans the interest is capitalised, so the borrower does not make cash payments during the build and the balance rises each month. Terms differ. Some lenders require interest to be paid in cash, particularly where the borrower has other income, and smaller or bridging-style loans may deduct interest in advance. The facility agreement states which applies.

Is the interest reserve included in loan to cost?

Usually, and the agreement's definition should say. The reserve is drawn as debt and is a cost of the project, so the common treatment puts it on both sides of the ratio; some lenders leave it out of both, which reads lower. In this page's example, US$12.0m of debt against US$17.0m of cost reads 70.6%; with the reserve of US$0.89m on both sides it is 72.1%. The gap widens with higher rates and longer programmes.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Interest Reserve: a Worked Example

The building pays no interest. The loan pays it for the building.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

A building under construction earns nothing, so a lender that wants its interest during the build has to lend it. The interest reserve is the budget line that does this: each month's interest is drawn from the facility and added to the debt, and no cash sits aside anywhere. Its size depends on the pace of the drawings, the rate and the months until repayment. That makes it the line most exposed to delay, and the one a lender reworks whenever the programme moves, because interest does not stop when the builders do.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// MAKE THE CALL

Issue 08 — Basalt Ridge Developments. A new-to-bank developer, a claimed 28% ROE and two other banks circling. Your bank has a growth target. Your call first, then the senior banker's.

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PART OF Property Development Finance

// 01 — WHY A BUILDING CANNOT PAY ITS OWN INTEREST

A term loan on a let warehouse is serviced from the rent. A development loan has no rent and no sales until the work is finished, and often not for some months after. The developer could pay the interest from elsewhere, but most developers have put their spare cash into the equity, and a lender would rather know the cost is funded than rely on a promise to find it each month. So the interest goes into the budget beside the construction, the fees and the contingency, and the facility limit is set high enough to carry it.

The word misleads. In many New Zealand, Australian and UK development facilities the reserve is not an account with money in it; it is a slice of the limit, undrawn until each month's interest uses it. UK lenders often call the same arrangement rolled-up interest; some instead retain the interest, deducting the estimate from the loan at the start. Elsewhere, and in some deals, a reserve really is cash paid in by the borrower and held in a separate account. The agreement says which, and the US bank supervisor's handbook recognises both forms.

// 02 — HOW THE RESERVE IS SIZED

Quick estimate = debt before interest × average share drawn × rate × years

Budget figure = month-by-month schedule: opening balance + draws,

× monthly rate, interest added to the balance

The quick estimate is useful for a first look and too low for a budget, because it ignores interest on interest and averages the drawings. Four inputs drive the proper schedule. The shape of the drawings matters first: equity goes in before the loan on most facilities, so the debt starts late, and a build that spends early carries more interest than one that spends late. The rate matters next, and on a floating-rate loan the rate in the schedule is an assumption unless it is hedged. Then the length of the build. Last comes the tail, the months between practical completion and the money arriving, which is when the balance is at its highest and each month costs the most.

The reserve then feeds back into the loan. It is debt, so it counts in loan to cost and in the peak the facility has to reach. A ratio worked before interest flatters the deal.

// 03 — THE EXAMPLE

A developer is building a self-storage facility to sell to an operator on completion. The case is constructed for this page like every figure in it. Total cost before interest is US$17.0m: US$5.0m of equity goes in first, then US$12.0m of debt is drawn at US$1.0m a month for twelve months. The rate is 9%, added monthly, and the sale is due to settle three months after completion. The rate and the programme belong to the example and are not offered as a market norm.

Quick estimate (US$m)

Build: 12.0 × 50% × 9% × 12/12 = 0.54

Tail: 12.0 × 100% × 9% × 3/12 = 0.27

Total at simple interest = 0.81

Monthly schedule Interest to date Balance

Month 12, build ends 0.60 12.60

Month 15, sale settles 0.89 12.89

Facility limit = 12.00 + 0.89 = 12.89

Loan to cost: 12.89 ÷ (17.00 + 0.89) = 72.1%

Before interest: 12.00 ÷ 17.00 = 70.6%

Now the programme slips. Nine months in, the work slows, and the last US$3.0m is drawn over six months rather than three. Completion moves to month 15 and the sale to month 18. No construction cost has risen.

Delayed schedule Interest to date Balance

Month 15, build ends 0.85 12.85

Month 18, sale settles 1.14 13.14

At month 15: undrawn limit (12.887 − 12.853) = 0.034

interest still to come = 0.291

shortfall = 0.257

The reserve was budgeted at US$0.89m and the interest is now US$1.14m, a shortfall of about US$0.26m on unrounded figures. It has to come from somewhere, and the lender finds it long before month 15, because the cost-to-complete test includes interest still to come. A rate two points higher throughout would have added about US$0.21m on the original programme.

// 04 — HOW IT DIFFERS FROM CAPITALISED INTEREST

The two are used interchangeably and are not the same thing. Capitalised interest describes what happens to the interest: it is added to the balance rather than paid in cash. The interest reserve is the amount of the facility budgeted to allow that. A loan can capitalise interest with no budgeted reserve, in which case it simply runs through the limit, and a reserve can be cash paid in by the borrower with no capitalisation at all.

A debt service reserve account is a different thing. It belongs to the operating life of a project, holds real cash or a letter of credit, and exists to cover a shortfall in income that was expected to be there. An interest reserve covers a period when no income was expected.

DEFINED IN ONE PARAGRAPH → · CAPITALISED INTEREST → · DRAWING A DEVELOPMENT LOAN →

// 05 — WHERE IT DECIDES A FILE

A reserve hides things by design. While it is being drawn, the loan is not late and a covenant has nothing to catch, so a project in difficulty can look current for months. The US supervisor's handbook warns of this directly, and describes topping up a depleted reserve with more debt as a red flag for credit deterioration. A lender that increases the reserve is making a new credit decision and should read it as one: is the project still worth more than the debt will now be, and has the valuation been looked at again?

At approval, the questions are whether the programme behind the schedule is the builder's or the developer's hope, what rate was used, and how long the tail really is once titles and settlements are allowed for. During the build, the lender compares interest used with work done. A reserve being used faster than the work is advancing is the early sign that the file is heading for a shortfall. When it arrives, the usual answers are more equity, a guarantor's cash, or a smaller scope. A larger loan is the answer that needs the most justifying.

PROPERTY DEVELOPMENT FINANCE → · THE DEVELOPMENT LOAN FILE → · COST TO COMPLETE →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Office of the Comptroller of the Currency (United States), Comptroller's Handbook: Commercial Real Estate Lending, version 2.0, March 2022 — 'Interest Reserves', pages 7–8 — A bank supervisor's description of the mechanism, which is not specific to the three markets this site covers: a reserve may be a budget line or borrower-funded cash, a delay commonly depletes it, and refilling it with debt is a red flag — sections 01 and 05.

// QUESTIONS PEOPLE ASK

How do you calculate an interest reserve on a construction loan?: For a first estimate, multiply the debt before interest by the average share drawn, the rate and the length of the build in years, then add the months after completion at the full balance. For a budget, build the schedule month by month, adding each month's draw and charging interest on the running balance, including earlier interest. The month-by-month figure comes out higher because the interest itself earns interest and each draw is charged from the day it is made.
What happens when an interest reserve runs out?: Interest is still due, so the shortfall has to be met. The lender's test of whether the remaining money will finish the project usually shows it before the reserve is empty, and funding can stop until the developer or a guarantor puts in cash. The alternatives are cutting scope or asking the lender to increase the limit, which is a fresh credit decision and normally brings a new look at value and feasibility.
Do you pay interest during construction on a development loan?: On most commercial development loans the interest is capitalised, so the borrower does not make cash payments during the build and the balance rises each month. Terms differ. Some lenders require interest to be paid in cash, particularly where the borrower has other income, and smaller or bridging-style loans may deduct interest in advance. The facility agreement states which applies.
Is the interest reserve included in loan to cost?: Usually, and the agreement's definition should say. The reserve is drawn as debt and is a cost of the project, so the common treatment puts it on both sides of the ratio; some lenders leave it out of both, which reads lower. In this page's example, US$12.0m of debt against US$17.0m of cost reads 70.6%; with the reserve of US$0.89m on both sides it is 72.1%. The gap widens with higher rates and longer programmes.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Credit analystReads a borrower and writes the recommendation a decision-maker will act on.
Credit sanctionerHolds delegated authority and signs — or declines — the lending the front line brings.
Workout and recoveries managerTakes the files that have gone wrong and works out how much the bank gets back, and how.

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SIGNAL OR NOISE · THE ECONOMY · COLLATERAL MARKETS

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THE READING ROOMIN ONE PARAGRAPHInterest reserve What is an interest reserve on a development loan?