What formulas do lenders use to calculate interest reserves on construction loans?

Borrower:

Calculation of interest reserve depends on the size, complexity and sophistication of the construction loan analysis. There is no single rule about how to calculate it, but I guess there are at least three main approaches to do it.

The simple approach to calculating interest reserve: Assume full utilization for the length of the construction loan.

The usual approach to calculating interest reserve: An estimate of the outstanding under the construction line is used. As in “expected utilization of the construction credit line is expected to be at an average of 50%”

The complicated/detailed approach of calculating interest reserve: The way that the line is going to be used is looked at by estimating the future draws, which are related to the way that the construction is expected to advance. I guess the easy way to understanding this approach is thinking of it as a weighted average. This is done by using a spreadsheet, but the calculations behind the concept are not that difficult.

Remember that you also have to take into consideration that the construction loan will probably be a floating rate, and that the lender will surely account for a small rise in this rate when doing the calculation. You can also expect the lender to give itself some wiggle room on the interest coverage for comfort.

Hope this helps.

Dear Administrator:

Given the complexity involved, what would be a good rule-of-thumb? As a percentage of the loan amount, what would that percentage be? 5%? 6%?

Thanks in advance,

"Given the complexity involved, what would be a good rule-of-thumb? As a percentage of the loan amount, what would that percentage be? 5%? 6%?

There is no rule of thumb, the interest reserve is calculated on a deal by deal basis. However, the cushion that the lender requires is usually not that much.