I am looking at interest reserve thats financed wrong, please explain
Can you guys help me out here. If your a lender and you lend a $1M, but are willing to finance an interest reserve. Lets say in that its a six month term and the total interest for six months is $100k(making it simple). So lender lends $1.1M (with interest reserve) and borrower in six months just pays down $1.1M. So the lender literally made no money since they just got what they lent back. Can someone explain this or am I thinking of it wrong?
The $1mm is sized inclusive of the interest reserved. At the most simple level, assume the whole loan exluding the $100k interest reserve is funded upfront, so $900k. the borrower can then “pay” interest via the reserve (capped at $100k; thereafter borrower will come out of pocket for interest to balance loan), which will just be a journal entry - but considered advances such that the $1mm loan is funded.
But On a net basis, on day one lender funded $900k, booked $100k of contractural interest via journal entries, and gets $1mm upon maturity (i.e., the loan amount)
Make sense?
Understood. In this case the borrower is funding the interest out of pocket though. However what if the interest reserve is financed, or is normally done out of pocket?
To be clear, what I just described is an interest reserve that was “financed” by the loan (i.e., 100k of a $1mm loan allocated to interest payments). Borrower only comes out of pocket to the extent the $100k is depleted. Make sense?
Ok I understand what you're saying. I think I was over complicating it. The $100k is a separate entry and they are essentially pre booking the interest as income sort of.
Basically, it looks like this:
Total loan size: $1,000,000
Initial Funding: $900,000
Interest Reserve: $100,000 (Let’s assume 12 monthly payments of $8,333 for the example below)
Day 1: Lender funds $900,000
When the first loan payment comes due, the lender says to the borrower: “borrower, you owe me last months interest which equals 1/12th of the interest reserve ($8,333). I will draw down on the interest reserve to pay myself. (Effectively moving money from the “right hand to the left hand”). I will increase your loan amount by $8,333. Now your loan balance outstanding is $908,333. Your remaining interest reserve is $91,667. Next’s month’s interest payment (which will be paid out of the reserve) will be based on this updated principal amount.
It’s just moving money around in a sense. It helps you slowly get more money out the door even if you technically aren’t actually “getting the money out the door.”
In this example, wouldn’t you want the principal balance to be $1,000,000 from day one (not $900,000)? If it’s a true interest reserve that’s funded day 1 (and not a future advance), you’d treat the $100k interest reserve as having been advanced on the origination date, and interest would accrue on the full $1mm every month. If you increase the principal every month as interest is drawn from the reserve, you’re increasing the principal balance that the interest is accruing on and you’re going to run out of that interest reserve more quickly than 12 months.
You could structure it the way you described but you wouldn’t get 12 even payments of $8,333.
Good catch. Yes. Was trying to conceptually and mechanically show what it looks like. But yes, interest payment will increase each month as principal balance increases. Therefore you will run out of reserves faster.
It can be structured two ways, one capitalized up front where it’s paid for, similar to how you might capitalize equity in the beginning of the deal. Or two, and more likely, held back by the lender and paid as needed.
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