Four Tips To Calculate an Interest Reserve

In integral part of any construction financing package is to create a reserve of funds to pay the monthly interest. This is possible because construction financing traditionally requires only interest payments to allow you to focus on completing your project. Interest reserves are common in construction lending but calculating the amount can be complex; especially with larger projects. If the reserve is too small it will
run out before the project is complete, and if it is too large you will over pay on loan fees.

• Budget your project: There are a number of expenses that you will face including your acquisition cost (if you don’t own the property), construction costs, and soft or other costs. Construction costs primarily consist of your materials and labor, while soft costs include insurance, taxes, legal and professional fees, and marketing. Remember that setbacks with any project can occur so adding a small contingency to you budget to account for these issues is a good idea.
• Plan your timetable: Once you have budgeted, plan out the construction time frame in bi-weekly or monthly increments. This will give you an understanding of how much of your construction loan will be outstanding at every period, which is important for calculating your reserve. Also, it will most likely be required by the financial institution you are doing business with. It is important to keep in mind that delays may occur in construction so make sure to plan for them.
• Know your interest rate: Construction loans are based off of either the Wall Street Journal Prime Rate (Prime) or the London Interbank Offered Rate (LIBOR) rate index. The former is tied to the federal funds rate, which may change at irregular intervals while the latter is quoted at intervals of either three,
  six, or twelve months. Talk with your financial institution about which rate index they will use, and how many basis points they are charging.
• Putting it all together: Your monthly interest expense is calculated when you multiply the outstanding loan balance at month’s end by your quoted interest rate, and your estimated interest reserve is the sum of those monthly interest payments.. It is important to note that you must divide the interest rate by 12, to accurately reflect monthly payments.

Technorati Tags: Interest Reserve, LIBOR, Prime, Construction Loan

Posted on April 2nd, 2007 | By: bootstrap economist | Filed under Banking

Leave a Reply

You must be logged in to post a comment.