What is Interest Reserve & How is it Calculated? Also, Drawn vs Gross Balance Interest Calculation
Updated: Jun 17, 2020
Drawn Balance vs Gross Balance Interest Calculation
Before we start a conversation about the Interest Reserve let's talk about a couple of different ways that interest is calculated. The methodology used to calculate interest can make a big impact on the cost of a loan so it's important to always ask a potential lender the question, "how do you calculate interest?". It's not that calculating interest one way over another is bad or good, it's just that you need to understand if you are really to compare apples to apples, one lender to another.
A construction loan is a loan in which a lender approves the borrower for a specific loan amount and then allows the borrower to take draws periodically to fund payment of construction related expenses. The two main schools of thought with construction loans are to:
A) charge the borrower interest on the entire loan amount beginning day 1 and every month thereafter until the loan is paid off (referred to as interest calculated on the "Gross Balance"), or
B) charge the borrower interest only on the actual drawn/principle balance at the end of each month until the loan is paid off (referred to as interest calculated on the "Drawn Balance" or "Principle Balance").
Calculating interest on the principle or drawn balance often results in less interest being paid towards a loan even though the actual annual interest rate may be higher because interest is only calculated on funds actually used by the borrower. Principle balance interest is therefore often a far less expensive than gross balance interest even though the interest rate may be higher on a principle balance loan.
Here is an example demonstrating that a lower 8% rate on the gross balance of a $1,000,000 construction loan is actually about 40% more expensive than a 10% interest rate calculated on the principle balance of the same loan:
Click below to download the sample file in the image above.
Builders Capital typically calculates and charges interest based on the principle balance of a loan at the end of each month rather than the gross balance. However, many of our competitors calculate interest on the gross balance only. Those lenders sometimes convincingly claim they have cheaper rates than ours in hopes that the borrower doesn't realize that a lower interest rate, calculated on the gross balance instead of the principle balance, will actually cost the borrower a lot more money over the life-cycle of the loan. In my opinion, this is a bate and switch and something that savvy borrowers should be aware of before making their borrowing decisions.
The Interest Reserve
When structuring new loans many borrowers prefer that their lender hold some or all of their interest in reserve to facilitate the interest payments on their behalf. Think of an Interest Reserve ("IR") as a bucket of money that is set aside at the beginning of the loan strictly for making interest payments. Adding an IR to the loan is convenient for the borrower because it allows the lender to withdraw interest payments each month from the IR rather than requiring the builder to make monthly interest payments via check, wire transfer or other means. Additionally, if a builder has inconsistent or poor monthly cash flow the IR eliminates the stress associated with making that monthly payment. Furthermore, if the borrower has all of their cash tied up in down payments, land acquisitions, overhead or if they are simply trying to keep cash in their bank account to show liquidity for financing purposes the IR may allow them to grow their business without the need to expend that cash throughout the duration of their loan.
Lenders often like it when interest reserves are included with construction loans because the IR ensures the interest payments will be made on time. Also, because the IR is essentially a bucket of money set aside at the beginning of the loan the lender can charge interest on the balance of the interest reserve bucket at the end of each month. The IR balance of course decreases throughout the life-cycle of the loan as interest is removed from it to make your interest payments. The result of having an IR on the loan, from a lender perspective, is that an IR can strengthen the loan a little. It reduces lender risk while slightly increasing the lender's Internal Rate of Return on the loan. The caveat, or downside to adding an IR to the loan, at least from a lender's perspective, is that an IR can mask or hide a borrower's inability to pay if for some reason a borrower's business begins to struggle. Some construction lenders require or simply automatically include an IR on construction loans. For many lenders it is optional.
Calculating the Interest Reserve
To calculate the amount of interest to hold in reserves on a loan the lender must determine the amount of interest expected throughout the duration of the loan. If interest is being calculated on the monthly drawn balance the lender must estimate the interest that will be needed, making some assumptions as to what the builder would likely draw each month. This is because it is impossible to accurately predict exactly how much money in any given month a builder will draw towards construction of their project. Often the straight-line method of calculating interest (an average) is used meaning the lender assumes for estimating purposes that the same amount of funds will be withdrawn each month until the project is completed and the loan is paid off. Here is the same example shown above, but with an IR built in along with interest calculated on the IR separated out for educational purposes. Clearly the cost of the loan is slightly higher with the IR than without (shown above) - a trade-off for convenience and for strengthening the loan.
When should you use or not to use Interest Reserve?
Some borrowers come to me with an idea already in their mind that they either do or do not want an IR on their loan. Usually, I look at each loan scenario with and without the IR anyway and then I still make a recommendation to the borrower as to whether I think an IR should be included or not. Often when borrowers have a lot of liquidity (financially strong) I will recommend that they do not use an IR. If a borrower is tight on cash I may recommend that they do use an IR.
Borrowers should understand that adding an IR to the loan does change the LTC ratio and the LTV ratio. That means that having an IR can also impact the cash to close (down payment) requirement of a loan. If, for example, the lender will fund loans up to say 90% LTC, and if the loan has already reached 90% LTC before the IR is added, then the IR amount will simply be added to the down payment. In other words, using simple numbers if your loan has say a $25,000 down payment at 90% LTC and your IR would be say $5,000, then adding the IR to the loan would cause your down payment to increase by $5,000 to $30,000. In my mind in that scenario you are simply pre-paying your interest reserve while also being charged interest on your pre-paid interest reserve. In that scenario, I would generally recommend that you do not include an IR on the loan. The exception to that recommendation, for me, would be if there is a weakness we are trying to surpass (like low credit score, a high risk scenario, or something like that) in which case sometimes strengthening the loan by adding an IR or increasing the down payment could be worthwhile.
Always ask your loan officer if an IR is available and if they recommend you include an IR in your loan or exclude it.
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