From the desk:Ground-Up Residential Development (Spec Home Building)

Who actually pays the "interest reserve" on a construction loan?

Got a term sheet back for a single spec house, first one for me. Lot's already mine, bought it last year for 62k with cash. Build budget from the contractor is 288k for 1,850 square feet, which is about 156 a foot, and he says that's good for our market. Target sale in the mid 400s.

The lender's sizing the loan at 85 percent of cost with the lot counted as my equity. Fine, I think. What I can't work out is a line called interest reserve, 21,000, listed inside the loan amount. So the loan pays my own interest to the lender? And then it accrues interest on itself?

Also the draw schedule has seven draws and each one needs an inspection. The contractor asked for 15 percent up front for materials and mobilization and the first draw doesn't release until foundation is complete. I don't know who's supposed to float that gap, me or him, and I don't want to find out on week two.

Budget is 288k plus 21k reserve plus roughly 9k in fees and points. So I'm carrying 318k of debt against a build I priced at 288k, and my contingency is... 6k? That's the part I keep staring at. Everything I read says materials keep drifting up 3 percent plus a year, and I have one line item of 6k for surprises across a nine month build.

Do I ask the lender to size the loan bigger to hold a real contingency, or does asking for that make them think I priced it badly? Genuinely don't know which way that reads.

Answer

1stephen_ok9CO2CPRO6

Asking for a bigger loan to hold contingency doesn't make you look sloppy, it makes you look like you've built before. What makes you look sloppy is coming back at month six asking for a budget increase mid-project, when the lender's collateral is a half-finished house and their options are bad.

One caution though, from the side that looks at these as investments. The lender caps at 85 percent of cost, so adding 25k of contingency to the budget doesn't just hand you 25k of loan. It adds roughly 21k of loan and 4k of your own cash to the equity requirement. Run that before you ask, so the conversation is about a number you can actually fund.

And on your 156 a foot. Is that the contractor's number for his scope only, or all in? Site work, permits, utility connections, driveway, final grade and landscaping live outside a lot of builder quotes. Ask him for the exclusions list in writing. The exclusions are where first-timers lose the margin.

2 replies

2omar_haddadActivePRO11

6k of contingency on a 288k build is a rounding error. I do renovations, not ground-up, and I still price 10 percent minimum, because the surprises on my jobs come out of walls that already exist. Yours come out of dirt, weather, and a framing crew that got a better offer across town.

On the interest reserve: yes, the lender funds your monthly interest out of the loan itself, and yes, drawn reserve dollars accrue interest like any other drawn dollars. It exists so you're not writing a check every month during a period when the house produces nothing. It isn't free money, it's your own future payoff moved forward. Two things to confirm in writing with them: whether unused reserve reduces your payoff at the end, and what happens if the build runs past the reserve's assumed timeline. Nine month reserve on a build that takes thirteen months means you're paying cash for months ten through thirteen at exactly the moment you're most stretched.

The mobilization gap is a real fight and it's worth having now. A lot of builders want money before the first inspection draw. Some lenders allow a soft cost or materials draw at closing. If yours doesn't, you're the bank for that 43k, and you need to know that today rather than in week two like you said.