What Is an Interest Reserve? How It Works on Construction Loans
An interest reserve pays a construction loan's interest until the project is sold or leased. Here is how it is sized and why regulators flag repacked reserves.
Why it matters
- An interest reserve is an account, usually funded as a line item in the construction loan budget, that pays the loan's interest during construction and lease-up, according to the OCC's Comptroller's Handbook.
- The OCC says a reserve should cover interest through the project's expected completion and lease-up, sale or occupancy, and that sizing should allow for possible changes in interest rates.
- Adding debt to refill a depleted reserve, known as repacking, is "a red flag indicating possible credit deterioration," the OCC says.
Explainer: background on how this part of the market works.
An interest reserve is an account set up by the lender and used by the borrower to pay loan interest during construction and lease-up, according to the Office of the Comptroller of the Currency's Comptroller's Handbook on commercial real estate lending. It is usually funded as a budget line item in the construction loan, so the lender is in effect lending the borrower the money to pay its own interest.
The OCC's guidance is written for the banks it supervises. Private and hard-money lenders set their own policies, but the risks the OCC describes apply to any lender whose loan pays itself.
How does an interest reserve work?
The reserve can be built into the loan, or the borrower can fund a separate escrow account as a condition of the loan, the OCC says. Interest is paid from the reserve each month, so the loan stays current while the project earns no income.
According to the OCC, an appropriate reserve "provides sufficient funds to pay interest through the project's anticipated completion and lease-up, sale, or occupancy." The handbook lists key questions for sizing it:
- Are the assumptions reasonable, including possible changes in interest rates, the timing of draws and paydowns, and the time needed to finish and sell or lease the project?
- If the borrower plans to pay interest itself, is there enough equity for the lender to fund the interest if needed while staying within its loan-to-cost and loan-to-value limits?
A worked example
The figures below are illustrative, not market quotes. Assume a $2 million construction loan drawn in 12 equal monthly amounts, interest-only at a fixed rate, then six months of lease-up with the full balance outstanding.
| Rate | Interest during construction | Interest during lease-up | Total reserve needed |
|---|---|---|---|
| 10% | $108,333 | $100,000 | $208,333 |
| 12% | $130,000 | $120,000 | $250,000 |
Because the loan is drawn over time, construction interest is roughly half of what the full balance would cost. Two points of rate add $41,667 to the reserve. A three-month delay at 12% would add another $60,000. The example leaves out interest on the reserve itself and fees, which push the real figure higher. Our loan-to-cost explainer shows how a bigger reserve raises total project cost.
Should a bridge loan on a stabilized property have an interest reserve?
Generally not, according to the OCC. Using reserves to pay interest on loans "that should be generating cash flow," such as loans on stabilized properties or speculative raw land purchases, "is generally not appropriate," the handbook says. A stabilized property's cash flow should carry its own debt service.
During lease-up, any cash flow from the project is ordinarily applied to interest before the reserve is used. Once cash flow covers the interest, the OCC says, no further draws on the reserve should be permitted.
What happens when the reserve runs out?
Reserves are sometimes used up before a project is finished, often because of construction delays or a change in market conditions, the OCC says. Banks generally require the borrower or guarantor to add cash. If they will not, a bank may "repack" the reserve by lending more to keep the loan current, which can mask a nonperforming loan.
The OCC calls the decision to repack with debt "a red flag indicating possible credit deterioration." To support it, the handbook says, a lender should get a new appraisal or evaluation and recheck whether the project still works in the current market. Repacked reserves also appear on the OCC's list of warning signs, alongside draw requests ahead of schedule and construction delays. Our guide to construction draws on fix-and-flip loans covers the related draw controls.
For current benchmark rates, see our rates and data page, and find more underwriting coverage in the hard money section.
Sources
- Office of the Comptroller of the Currency, Comptroller's Handbook: Commercial Real Estate Lending, Version 2.0 (PDF) (March 2022; reputation-risk references removed March 20, 2025)
- Worked example figures are illustrative calculations, not market data. Loan terms and reserve policies vary by lender.
