How Does a Hard Money Interest Reserve Work?

If you’re taking out a hard money loan, one thing to consider is setting up an interest reserve to cover the monthly payments for a few months or for the entirety of the loan, whichever you prefer. An interest reserve can be a great tool for managing the cashflow of a project, allowing an investor more time to focus on the building rather than the finances.

This blog post will cover how a hard money interest reserve works, including:

  • How Does an Interest Reserve Work?
  • What Happens to Unapplied Interest Reserve Funds?
  • What Happens When the Interest Reserve Is Used Up?
  • Interest Reserve for Construction Loans

How Does an Interest Reserve Work?

An interest reserve is an amount set aside at origination to cover the monthly payments of the loan. In hard money lending, where 12-month bridge loans are the most common type of loan, we will often set aside 12 monthly payments from the proceeds of the loan at the close of escrow.

For example, if we’re funding a 12-month bridge loan of $1,000,000 at an 11.00% rate with a $9,166.67 monthly payment, the interest reserve amount held back at the close of escrow would be $110,000.

Interest Reserve Hard Money Loan

Interest reserve funds are placed with the loan servicer, assuming the lender uses outside loan servicing. If the lender services their loans in-house, they will hold onto the funds and credit the account each month on the due date. Borrowers will receive regular servicing statements each month reflecting funds applied to the previous payment and next payment due. The only thing different is that borrowers do not have to write a check or have funds electronically drafted from their bank account – funds have already been set aside to service the debt.

When using an interest reserve on a 12-month bridge loan, borrowers do not have to set aside twelve payments. They can do 1, 3, 6, 9, or whatever number of payments they need. The number of payments for the interest reserve is flexible for each borrower and each situation.

Note: Consumer bridge loans do not allow for an interest reserve.

What Happens to Unapplied Interest Reserve Funds?

If you have a 12-month bridge loan with a 12-month interest reserve and sell the property after eight months, you will be refunded the remaining four months from the interest reserve account. The lender is not entitled to those funds and will return those funds to you.

What Happens When the Interest Reserve Is Used Up?

If you took out a 12-month hard money bridge loan with a 6-month interest reserve, you would have to start making regular payments in month seven until either the loan is paid off through a sale or refinance. The funds set aside at origination covered the first six months but did not cover the remainder of the term, months 7-12. Those payments are on the borrower to make on-time payments each month on the loan.

Interest Reserve for Construction Loans

Where I see interest reserves used the most are in construction loans, which start out with an initial draw at the outset of the loan with the balance increasing as funds are drawn to cover costs in the build.

Below is an example of a $4,500,000 construction loan that started out with an initial $1,500,000 draw, followed successive $1,000,000 draws until the loan maxed out at $4.5 million:

Interest Reserve Construction Loan

During the underwriting period, the lender and borrower determine the costs and timeline, coming up with a draw schedule and scope of work that calculates how much interest reserve to set aside for each month and for the overall loan. This example has a $337,497 total interest reserve to cover 15 months of stair stepped payments known as Dutch Interest, on the construction loan.
(“Dutch Interest” is when the payments increase as construction funds are drawn whereas “New York Interest” is where interest is charged on the entire loan amount of $4,500,000 from Day 1, which would in the example, would be $562,500 ($37,500 x 15 payments) rather than $337,497).

Conclusion

Hard money interest reserves can be beneficial for real investors using bridge loans and even better when used for construction loans. Interest reserves allow the investor to focus on the project and less on the finances. The interest reserve can be as little as one month all the way out to the maturity date, covering 12-24 months on a bridge loan. Any unapplied funds are returned to the borrower when the loan pays off. If the interest reserve runs out, then the borrower is responsible for making on-time payments each month on the loan until it is paid off through a property sale or refinance.