How to Use an Interest Reserve for Your Next Construction Loan
To be a successful and profitable developer, no matter your scale, you need to understand construction loan options. Unless you’re leveraging equity with a line of credit, new construction requires a different type of construction financing than a traditional asset purchase.
Construction loans are incremental loan products designed to fund the construction of a new property or development. They have a much shorter loan term than a traditional mortgage, usually between one and two years. Furthermore, an additional product is often tacked onto a construction loan, commonly called an interest reserve construction loan.
How are Funds Dispersed on a Construction Loan?
During the loan term, funds from the loan, aka “the draw,” are released in installments to suppliers and the contractor with each stage of construction completed. The contractors submit requests for payment using the American Institute of Architects (AIA) Application and Certificate for Payment form once work is completed according to the specifications, budget, and schedule. As the payments are released, construction interest begins to accrue on these amounts because interest is only charged on the accrued amount.
Standard Interest Rate on a Construction Loan
Construction loans are shorter-term loans with a higher associated risk, so the construction interest rates are considerably higher than a standard mortgage. In addition, these interest rates are usually variable, meaning that they go up and down with changes in market conditions. In the current interest rate environment, that could result in construction interest rates quickly rising with each Federal rate hike, making it challenging for brokers to estimate rates.
Once construction is officially complete, and a certificate of occupancy is issued, the borrower then works with a lender to obtain traditional financing for the investment. Pursuing this lending route typically offers a lower interest rate option for the borrower than the construction loan itself.
Why are Interest Reserve Loans Used?
If the borrower defaults on the loan and construction halts, a bank may foreclose on the loan. As a result, they are usually left with a partially completed property that they likely need to complete to recoup their costs. Therefore, a construction loan is considered a higher-risk investment for lenders than an acquisition, bridge, or refinance loan.
When the construction loan structure does not include an interest reserve, the risk for the bank increases. Therefore, an interest reserve loan is a product that usually accompanies a construction loan.
How Do You Calculate Interest Reserve on a Construction Loan?
Construction loan borrowers often struggle to understand how to calculate construction period interest and their interest reserve requirement. It’s crucial to understand interest costs to determine if a development will be profitable. Because interest on a construction loan is different from other types of commercial mortgages, developers should project interest with an interest reserve calculation. Ultimately, interest reserve loan funds are a separate loan expressly set aside to pay the interest on the construction loan as it accrues, meaning that the approximate construction interest needs to be known well ahead of time.
The best way to get an accurate sum of the interest reserve calculation is to talk to the lender, as each lender will have its own calculation method. However, as a borrower, you can also come up with a reasonably accurate calculation using this method, which is a helpful tool to project interest costs for profitability modeling.
Early in the construction loan term, interest costs will be minimal as few funds will have been dispersed. But as construction progresses and more payments are dispersed, the interest adds up quickly. Hence, when calculating construction loan interest, you’re not applying the interest to the entire loan amount for the loan’s lifetime.
Interest Reserve Calculation Formula
The most common equation used to calculate interest on a construction loan is:
((50% x Loan Amount x Interest Rate) / 12) x Months of Construction
The use of 50% is to average the amount of loan principal dispersed throughout the entire term.
Suppose you want to be more conservative. In the case of a theoretical property’s construction having higher costs at the beginning of the loan term (for big-ticket items like excavation), you can increase this percentage.
Let’s apply this calculation to an example:
Loan amount: $1,500,000
Interest Rate: 5.1%
Construction time period: 18 months.
With this information and the above equation, we can determine that the average interest accrued per month is $3,187.50, making the total $57,375 for the loan term. Therefore, the interest reserve loan will need to be about $57,375 as a separately funded account responsible for paying the interest payable on the construction loan.
Each lender will have its own requirements, but this equation gives you the tools needed to make an assumption that you can fine-tune once you have more information.
Tax Implications of Construction Investment Properties
If you’re building an investment property or business property, the interest paid doesn’t qualify for a typical deduction. However, that doesn’t mean a tax deduction isn’t available with construction financing.
The interest paid on a construction loan can be deducted as a business expense, but only before and after the construction period. Interest paid during the construction period is not tax-deductible. The construction period is considered the time during which any physical construction is taking place, starting with the clearing of land or demolition. Therefore, instead of being an expense, the accrued construction interest must be added to the property’s cost basis and depreciated over 27.5 years. At Broadmark Realty Capital, we are experts on loans, not taxes. Consult with your CPA or a tax professional for advice on deductions.
Construction loan financing can be tricky – a professional loan broker makes it easy.
Unlike a typical investment loan, construction financing options can be challenging to understand with several moving pieces. Small and large-scale developers need to understand their options to calculate construction loan interest accurately.
Are you looking to finance your next construction project? Learn how Broadmark Realty can help.
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